The Nasdaq Composite Index collapsed from its March 2000 high of 5,100 to 1,700 by February 2001 and to a low of about 1,100 by August 2002. (diagram Nasdaq) - Diagram Dow
After recovering to 2,150 at the beginning of this year, it stands at about 1,900--just about 37 percent of its peak level three and a half years ago. (John Makin, AEI, 22/9 2004)

It is always a mistake to confuse a cycle with a trend. In the case of corporate earnings, it is worse than a mistake, it is a huge blunder.
The intense cyclicality of corporate earnings is the most important reason why the unadjusted p/e ratio is a worthless indicator of value.Martin Wolf

As with the first Shanghai Surprise, the stark reaction to this week’s Chinese events reveals deep lack of confidence in the health of the western corporate sector.
Even if the situation now stabilises — as it did for several months back in 2007 — the message of concern, in both west and east, is clear.
John Authers, FT 8 January 2016

Yet there were some very high numbers for a group of four companies that have come to be known as the “Fangs” — Facebook, Amazon, Netflix and Google —
and for a slightly wider group that added Microsoft, Salesforce, eBay, Starbucks and Priceline to create the “Nifty Nine”.
Both groups gained more than 60 per cent for the year.
John Authers, FT 3 January 2016

What you see here is a price chart of the mighty S&P 500 Index going back 20 years.

. It is called a moving average convergence/divergence (MACD) histogram, but that's just a detail. The message is the key. When the bars are pointing above the line, the market is in a bullish trend. When it points below the line, the bear is in town. Note that there have been two periods in the last 20 years where the indicator fell into bearish territory and stayed there.
These were the dot-com bubble burst and the financial crisis.

Alarming news?The Mebane Faber model based simply on comparing current stock prices to their moving average for the past 10 months.
MarketWatch 3 September 2015

Faber tweeted that the model recommended by his “old market-timing paper ends month 100% in cash & bonds.”
This has happened less than 7% of the time in the past, he said. “Last time? 2008/2009.”

It’s alarming news. The Faber model appears in his celebrated research paper A Quantitative Approach to Tactical Asset Allocation.
It is based simply on comparing current stock prices to their moving average for the past 10 months.
Back-testing it to 1901 suggests it would have spared you the worst of Wall Street’s biggest meltdowns,
and that over time it would have made you much more money than buy-and-hold.

Securities prices tend to plunge when investors suddenly think they are too high, and vice versa, and Keynes’s “animal spirits” are as full an explanation as we may ever have as to why this happens when it does.

But what we can usefully do, and hindsight is no objection to this, is to understand better why a situation was one particularly vulnerable to mood swings.

Things got so bad that former Treasury Secretary Larry Summers took to Twitter to compare the day’s events to previous meltdowns and say, “we could be in the early stage of a very serious situation.”
Bloomberg 25 August 2015

Turbulence in financial markets gathered momentum amid intensifying concern over slowing global growth, pushing the Dow Jones Industrial Average into a correction and giving other stock gauges their worse losses since 2011.

More than $3.3 trillion has been erased from the value of global equities after China’s decision to devalue its currency spurred a wave of selling across emerging markets. The worries over slower economic growth come as a strong dollar and plunge in oil prices take a toll on corporate earnings at the same time the Federal Reserve is contemplating the first boost to interest rates since 2006.

It took some 14 years, but we’re back to the real highs before the bubble pop
This slow-and-steady crawl has given us a return, finally, to the levels the S&P was at, inflation adjusted, at the tip-top of the dot-com bubble.MarketWatch 21 November 2014

Party Now, Apocalypse Later
Valuations are going to revert to the mean. They always do.
And when they do, they’ll overshoot in the process. The business cycle still exists.
Wolf Richter, November 19, 2014

The great unwind will happen in an environment when nearly everything is overvalued.
But those who have dared to stamp a near-term date on that event have gotten hammered by reality.

Junk bonds are enjoying the most extraordinary bubble ever.
Their justification: junk-bond default rates hover near historic lows of about 2%.
Sure. As long as cheap new money is available to service or pay off old debt, defaults are rare.

Three days ago Mr Debelle – a top official at Australia’s central bank – predicted that markets were heading for wild volatility, since investors were naive about structural risks.

A “sizeable” number of them, he observed, probably presumed that they could exit their positions before any sell-off.“History tells us that this is generally not a successful strategy,” he warned.
“The exits tend to get jammed unexpectedly and rapidly.”
Gillian Tett, FT October 16, 2014

We are not talking about rationality here but human nature. They are not one and the same thing. Adam Smith’s invisible hand is actually attached to human forearms, and humans are not only momentum investors, rather than value investors, but also inherently both greedy and suffering from hubris about their own smarts.

It’s sometimes called a bigger fool game, with each individual fool thinking he is slightly less foolish than all the other fools.Paul McCulley, January 2008

The Wall Street benchmark has lost 6.8 per cent since hitting a record closing high in September,
and market volatility has increased as investors fret that global economic growth is waning
just as the Federal Reserve concludes its third multi-billion dollar asset purchase programme.

Fund manager and prominent bear John Hussman is warning investors once again of the potential for a big market plunge
In the note, Hussman acknowledges that he’s proven “fallible” since 2009
MarketWatch 29 September 2014

He argues that he’s been miscast as a “permabear” — a “miscasting that may not become completely clear until we observe a material retreat in valuations coupled with an early improvement in market internals.”

History teaches that the market doesn’t offer executable opportunities for an entire speculative crowd to exit with paper profits intact.
Hence what we call the Exit Rule for Bubbles: you only get out if you panic before everyone else does.

Don’t confuse brilliance with a bull market
I’ve noticed that many long-time bears are capitulating. If you look at market history, when bulls feel invincible and beaten-down bears give up, you have the makings of a market top.
When the Fed attempts to extricate itself from the market one day, that’s when the music stops, and the blame game begins.
MarketWatch, Michael Sincere 23 September 2014

Next crash: $10 trillion like dot-com 2000? Subprime 2008How big a drop? Truth is, nobody really knows. But everybody has an opinion.First using this or that favorite theory, cycle, index, data, algorithm. Then they guess.Paul B. Farrell, MarketWatch 11 August 2014

Gigabytes of data endlessly overload us all day, every day, 24/7.

How big? Even the pros don’t really have a clue.

Does anyone really care, about the future? No, only today.

What’s trending now? Our brains have lost the capacity to think long-term. We drift from trend to trend: The latest buzz. Rarely going deep, never into the future. Nor ask the moral questions, what’s the right thing to do?

OBS 1972This stock bubble is ‘beyond 1929 and 2007,’ says John HussmanIt is easily beyond 1972 and 1987, beyond 1929 and 2007, and is now within about 15% of the 2000 extreme.
MarketWatch, July 27, 2014

Perhaps the most unhelpful of the psychological flaws we are prone to as investors is confirmation bias.
Our desire to seek out information that reinforces our existing beliefs and to reject anything that undermines our prejudices is powerful and dangerous.
Tom Stevenson Telegraph 10 November 2017

As Warren Buffett said:
“What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact."

behavioral economics
The threat was that of a paradigm shift. This term, coined by philosopher Thomas Kuhn, refers to the dread moment when scientists learn that up is down, black is white and everything they thought they understood about the world is wrong.
Noah Smith Bloomberg 1 June 2015

Cochrane definitely seems to think that the aim of behavioral economics is to replace the assumption of rationality with specific kinds of irrational thinking derived from psychology experiments.
If that could be done, that would truly be a massive paradigm shift in economics.

But it won’t happen -- at least, not in our lifetimes.
This is because psychology itself has no unified theory, at least not yet. Cognitive and social psychology are basically pre-paradigmatic sciences
-- they produce a huge amount of experimental results, but they don’t fit together into any coherent whole.

Exuberance is not always ‘irrational’
Stock market continuing to hit new highs almost daily despite the appalling geopolitical disasters
Robert Shiller may or may not have deserved a Nobel Prize for his academic work on behavioral economics
but as a practical guide to investing, his approach has been thoroughly refuted by real-world experience.
Anatole Kaletsky, Reuters, 25 July 2014

The implication is that Wall Street is grossly overvalued and that investors should prepare for a loss of at least the 40 percent retreat required to return the ratio to 16.

In fact, the expected fall from today’s vertiginous price level should logically be much bigger than 40 percent.
For the definition of an average requires that a long period of prices far above average must be balanced by an equally long period of deeply under-valued stocks.

Alan Greenspan suggested home prices could not fall; Ben Bernanke suggested the subprime mortgage market problems were contained; and
Janet Yellen argues complacency in the market is not a problem.
Axel Merk, Financial Times 9 July 2014

If ever the stock market flashed a ‘sell’ signal, it’s now
It’s not too late — yet — to move to cashMarketWatch 9 July 2014

Dow 17,000
Since 1929, stock-market rallies have had things in common that this one doesn’t
First, low interest rates have made other investments unattractive
Second, the investing public isn’t really buying stocks
David Weidner's WRITING ON THE WALL, July 8, 2014

Has the beginning of the end of the bull market begun?Unless corporate profitability has reached some kind of permanently high plateau,
the recent drop is just the beginning of a much bigger decline.
MarketWatch 25 June 2014

How much of the world’s fossil fuel reserves will eventually be burnt?
Either the world will abandon its pledge to keep emissions below the level thought to produce a temperature rise of 2C
or the fossil fuel companies are holding stranded assets and investing in unusable ones. Investors are implicitly betting on the former possibility.
Martin Wolf, Financial Times 17 June 2014

Deutsche Warns Markets Have Left The "Complacency" Phase, Have Entered Full Blown "Mania"
Tyler Durden zerohedge 9 June 2014

With a closing P/E ratio over 17 and a VIX under 11, Deutsche Bank's David Bianco is sticking with his cautious call for the summer. Their preferred measure of equity market emotions is the price-to-earnings ratio divided by the VIX.

Money Mania: Booms, Panics and Busts from Ancient Greece to the Great Meltdown by Bob Swarup. Bloomsbury Press
So what does Mr Swarup’s offering, Money Mania, add to the field? First it is unusually well-told, and expansive in scope.
Similarities between different episodes are breathtaking. Events in Ancient Rome and Athens, and Georgian Britain followed the same pattern as the crisis of 2008.
Review by John Authers, FT 27 April 2014

The problem is that we seem doomed to keep repeating financial crises. Other books have pointed out the cycle by which greed comes to overcome fear, credit is made too easy, and markets are taken way beyond what any economic fundamentals can justify, before they crash.

Stocks are telling you a bear market is coming
MarketWatch, May 14, 2014

Bear markets start with a whimper or a bang.

You may have noticed that some financial analysts on television seem confused.
One week they make a bearish prediction, then reverse course. This is typical as the market transitions to a bear market.

Many commentators are confused because what has worked in the past stops working.
Also, the behavior of other assets such as bonds and commodities don’t make sense.
That’s a clue the market is entering a danger zone.

Another red flag:
Investors are buying stocks on margin at levels higher than in the previous peak years of 2008 and 2000.
Whenever margin reaches excessive levels, bad things happen to the stock market.

My friend Josh Brown reminded us yesterday of this terrific chart from Jean-Paul Rodrigue,
a professor in the department of global studies and geography Department at Hofstra University.
Of course, the key question is: Where are we on the chart?
Bloomberg 18 March 2014

Everyone knows how the Great Depression fuelled support for extremists on both the left and right. Less well known is the way
the original Great Depression – the one that began in 1873 and involved a quarter-century of deflation – led to a wave of populism on both sides of the Atlantic.Causes dear to 1870s populists ranged from anti-Semitism to bimetallism. Nowadays anti-immigration and euroscepticism are more likely.
Niall Ferguson, FT April 18, 2014

Why Humans Are Hard-Wired To Create Asset Bubbles
I think that most bankers are in fact inherently decent people.
We just put them in situation in which their conflict of interest is tremendously high and their social norms are incredibly dysfunctional.
Adam Taggart, Peakprosperity, February 15, 2014

Human beings are incredibly forgiving, but nobody has really stood up and said, "I am really sorry. I made all of these terrible mistakes. I want this particular bank to start fresh and caring about people," right?
Nobody has admitted anything.

Not only does today's CAPE of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years coupled with sluggish earnings growth suggests that this market is also seriously overbought
Today's CAPE is just slightly less expensive than the 27x level seen at the October 2007 market peak and modestly below the level seen before the stock market crash in 1929.
John Mauldin, 27 January 2014

CAPERobert Shiller has been out there talking about a stock-market bubble again. “The boom in the U.S. stock market makes me most worried. Also, because our economy is still weak and vulnerable.”
Shiller has some clout among investors because he called a bubble in the U.S. housing market
via his book “Irrational Exhuberance” just as everyone thought prices had nowhere to go but up.
MarketWatch, December 2, 2013

Last week, Shiller said he was concerned about a rise in his cyclically adjusted price-to-earnings ratio, CAPE

PermabearSecular bear markets are not "one-way" down markets,
but a series of "cylical" ups and downs.
zerohedge, August 25, 2013

The bond market is an accident waiting to happen
When the bond market finally does crack, it is going to be one epic nightmare
that is going to make 2008 and 2009 seem like a picnic. Bill Fleckenstein, 21 April 2013

Lessons of the 1930s
Stiglitz describes a different view of the Depression which purports to overthrow the current macroeconomic understandingdecline in America's agricultural sector
The Economist Dec 13th 2011, by R.A.

THE economic rough patch of the past few years inevitably inspires comparisons to and reconsiderations of last century's big economic calamity. This week, in fact, The Economist features a briefing examining some as yet unheeded lessons of the Depression.

Economist Joe Stiglitz describes a different view of the Depression in Vanity Fair, which purports to overthrow the current macroeconomic understanding of the troubles of the 1930s. The Depression, he says, can be chalked up to decline in America's agricultural sector

For those of us who lived through the ERM crisis of 1992 and followed German events closely at that time, all this has a familiar ring.
It was not just recession in the UK, Italy, Spain, and parts of Scandinavia that caused the fixed exchange system to blow up, it was the deadly cocktail of slumps and banking troubles in these countries combining with German overheating. The mix triggered the final crisis.Ambrose Evans-Pritchard, February 21st, 2011

Based on one measure of volatility, stocks haven't risen this much amid price swings this narrow since 1971
Don't get complacent. CNBC 17/2 2011

The S&P 500 hit 1334 in morning trading Wednesday.You may not have inscribed that number on your forehead, but it is noteworthy all the same because it means the big-cap stock index has doubled its financial meltdown low of 666.79 on March 6, 2009.
CNN February 16, 2011

This week's 18% decline, and Friday's 1018.77-point swing from low to high, were the biggest since the Dow was created in 1896. Until now, the Dow's worst week was in 1933. Total trading volume of stocks listed on the New York Stock Exchange also hit a record, 11.16 billion shares.
The damage has been devastating both to households and to major investment institutions. Investors' paper losses on U.S. stocks now total $8.4 trillion since the market peak one year ago, based on the value of the Dow Jones Wilshire 5000 index, which includes almost all U.S.-based companies.
The blue-chip average is down 40% from last October's record, its biggest decline since 1974
Wall Street Journal 11/10 2008

People don't seem to grasp that we've had a historically long (since 1982),
broad (every asset class in the world) and
steep (e.g., the DJIA from under 1,000 to over 13,000, interest rates from 15+% to 5%)
economic and financial boom. It's gone on so long that everyone pretty much feels that prosperity and profit are just the way the world works.
Doug Casey, July 2007

The Business Cycle is driven largely by government intervention in the economy... most importantly, currency inflation.

These things give false signals to businesses and investors, which cause distortions and misallocations of capital. When, inevitably, the errors start to be corrected, the result is an economic downturn.

It will be called a "recession" if the government succeeds in preventing widespread bankruptcies and unemployment through one more dose of inflation.

Or it will be called a "depression" if things slip out of the government's control.

Am I predicting the Greater Depression may be upon us?
Well, I'm not a fortune teller.
But my gut feel is: yes.

The Fed can indeed be accused of being a serial bubble-blower. But this is not because it has been managed by incompetents.
It is because it has been managed by competent people responding to exceptional circumstances.Martin Wolf, August 22 2007

Anybody who has borrowed to buy securities – a category that includes a lot of banks – has a problem.
Lenders want their money back, but selling assets is difficult, so there is a squeeze on cash. That, in a nutshell, is what has been happening in the past couple of weeks and what may continue.
Financial Times editorial 18/8 2007

The falls have not made the market cheap. While the price of the S&P 500 index of US stocks may seem reasonable at about 15 times its earnings, those earnings are unusually high and will fall back at some point. Other real assets, such as houses in much of Europe and North America, are also expensive relative to their historical levels.

The market has been expensive for a long time, however, and trying to predict when it will fall has been a dangerous and unprofitable game.

With the world economy growing fast, now seems an unlikely time for profits or equity valuations to collapse. If you were happy to buy shares a month ago, there is little reason to sell them now.

The doubts burst into the open on August 9th when central banks were forced to inject
liquidity into the overnight money markets because banks were charging punitive rates to lend to each other.The Economist print 16/8 2007

Central bank intervention last Friday to inject liquidity into the global financial system
did not mark the beginning of the end of financial market turmoil.
It was merely the end of the beginning.
Liquidity injections will not deliver lengthy respite. The next phase of market volatility will be more vicious than before, led by downgraded ratings on credit instruments and followed by further dislocation in the credit markets that will spill over to equity markets.
Avinash Persaud, Financial Times 16/8 2007

The writer is chairman of Intelligence Capital Limited and an emeritus professor at Gresham College, London

Credit markets are the big brother of equity markets. In the US and Europe, capitalisation of private debt securities is a combined $28,000bn, compared with $23,000bn in equity markets.

Over the past 20 years, governments built regulatory systems to avoid credit problems at one bank becoming systemic. These systems succeeded, but only by shifting risks elsewhere. A measure of this failure is that the instances of emergency rate cuts have become no less frequent. Think of 1987, 1989-92, 1995, 1998 and 2001-03. Today, the principal avenues of systemic risk are via investment losses, not bank runs. The example from Japan in the 1980s and emerging Asia in the 1990s is that large and widespread investment losses will lead to big reductions in consumption and investment.

- Bond market turmoil sending investors fleeing from risk may be a worse predicament than the 1980s stock market fall and Internet bubble burst, Bear Stearns Chief Financial Officer Sam Molinaro said Friday.
"These times are pretty significant in the fixed-income market," Molinaro said on a conference call with analysts.
"It's been as bad as I've seen it in 22 years. The fixed-income market environment we've seen in the last eight weeks has been pretty extreme."
"So, yes, we would make that comparison" to market events that also include the debt crisis of the late 1990s, he said.http://money.cnn.com/2007/08/03/markets/bond_turmoil.reut/index.htm

It's time to panic. Why? I'll tell you. What has been frustrating for me is that, despite having forecast a number of our domestic economy's problems, the world's stock prices have embarked upon an almost unrelenting advance.
Doug Kass

This story originally appeared on RealMoney Silver on July 23, and is being reprinted as a bonus for TheStreet.com readers.

Turmoil reveals the inadequacy of Basel II
Harald Benink and George Kaufman, Financial Times February 27 2008

The turmoil in world financial markets, triggered by defaults on subprime mortgages in the US, raises questions about macroeconomic policy, financial stability and the design of financial regulation, including the new Basel II capital adequacy framework for banks.

The implementation of Basel II coincides with massive losses reported by some of the world’s largest banks, requiring large-scale recapitalisations. The risk models that anchor Basel II are basically the same as the ones many of these banks have been using in recent years.

Sheila Bair, chairman of the Federal Deposit Insurance Corporation in the US, recently noted that these models had important weaknesses which, in the light of today’s market turmoil, were a flashing yellow light to drive carefully.

The eurozone’s crisis has blown sky-high the idea that developed countries are 100 per cent safe.
A bank can buy all the Spanish debt (current rating: AA) it likes without having to back it up with a cent of capital
Lex, FT May 27 2010

One of the bedrocks of finance has been that sovereign debt is a sure thing. The risk-free rate, for example, is the yield on short-dated government bonds. The Swiss-based Bank for International Settlements also treats high-quality, longer-term debt as risk free for solvency purposes.

This position may no longer be credible.

To be sure, at 60 per cent, Spain has a much lower level of gross government debt versus the size of its economy compared with Italy, Ireland, Portugal and Greece. But the chance that Spain will default is no longer zero.

Larger polygamous financial institutions were allowed by the Basel capital regime to run with lower capital buffers than their smaller monogamous partners.
John Plender Ft Feruary 23 2010

As Andrew Haldane of the Bank of England has pointed out, bank profits ceased in the mid-1980s to be boring as the banks appeared to have discovered a money machine. While the return on assets, which reflects management skill in extracting profits from a pool of assets, was mediocre, the return on equity, powered by luck and leverage, soared. At the same time, larger polygamous financial institutions were allowed by the Basel capital regime to run with lower capital buffers than their smaller monogamous partners. Now this bias in favour of size has been made worse by crisis-induced mergers.

We are left with a financial system in which over-leveraged banking behemoths operate as an off-balance sheet adjunct of the public sector, while nurturing many profit centres that are increasingly oligopolistic. In wholesale finance, super-profits are generated by a handful of giants in opaque over-the-counter markets. In retail finance, there are numerous areas where oligopoly and customer inertia underpin excess profits.

It follows that bankers in the boom were being paid bonuses not for brilliance but for excessive risk taking via leverage and for oligopolistic super-profits.

It was the 1988 Basel Accord that first created the opportunity for regulatory arbitrage
whereby banks could shunt loans off the balance sheet.
John Plender, FT November 6 2007

In effect, a new capital discipline designed to improve risk management had the unintended consequence of creating a parallel banking system whose lack of transparency explains the market seize-up since August. As the new "originate and distribute" model reduced the incentive for banks to monitor the credit quality of the loans they pumped into collateralised loan obligations and other structured vehicles, the Basel rules failed adequately to highlight contingent credit risk. That is, when conduits and structured investment vehicles (SIVs) ran into difficulties, credit risk started to come back on to bank balance sheets, putting strain on bank capital.

Within banks executive bonuses and other incentives have the effect of encouraging a perpetual dash for growth at ever-increasing risk. Why be prudent when you can bet the ranch in the knowledge that a losing bet pays so handsomely?
The snag is that in banking, betting the ranch increases systemic risk.

“Where are the buyers getting the money to buy all of this stock and bond madness and act like a bunch of morons?”“‘Margin Debt’ Hits Record $353 Billion on NYSE”Mogambo Guru on Jul 24th, 2007

Why are the stock markets and bond markets rising?
For the only reason that there is: Because there are more buyers than sellers! Hahahaha!

Perhaps your question would have been better phrased as,
“Where are the buyers getting the money to buy all of this stock and bond madness and act like a bunch of morons?”

If that had been your question, I could have saved us both a lot of time by merely sending you to Online.wsj.com, which reports that, “‘Margin Debt’ Hits Record $353 Billion on NYSE”, which means that, “Investors are borrowing record sums of money to finance trades on the New York Stock Exchange.”

“Specifically, under Basel II, a broker-dealer must set aside just 56 cents in capital to hold US$100 of triple-A-rated securitizations.” Yow! Fifty-six lousy cents?

Bear Stearns’ sobering lessons
It raises questions about the exposure of market participants to risk, and the wisdom of aspects of the Basel II accords on bank capitalisation.Sean Egan, Financial Times August 2 2007

“The trend is your friend.”
That is an old saw on the market, and it has made many rich.When the trend breaks, you have nothing to hold on to. That is when panic ensues.
John Authers, Financial Times, June 8 2007

That is what happened on Thursday morning in the markets for government bonds, led by US Treasuries. It led to a wave of selling that threatened to change the underlying mathematics on which much of the world’s financing is based.

It also put the bull market in global stocks, now in its fifth year since equities began to recover from the bursting of the tech bubble in 2002, to one of its stiffest tests.

For 20 years, bond yields have been falling steadily. This reflects growing confidence that inflation has been squeezed out of the world economy.
Yields have fluctuated, but the peak of each cycle over the last two decades has been lower than the peak that preceded it.
Those peaks formed a perfect downward trend line. The straight line perfectly crosses all the peaks.

That line had been a great source of confidence. Once it was crossed – and that moment came when the 10-year yield reached 5.05 per cent early on Thursday in New York – traders had nothing left to hold on to. They started selling indiscriminately, with yields coming to rest at 5.13 per cent by the time most Wall Street traders left their desks on Thursday.

What caused that trend line to break? There was no news of any great importance on Thursday. Rather, an accumulation of evidence at last reached critical mass.

This is not yet the end of the five-year bull market in stocks. At 5.1 per cent, Treasury bond yields remain low by historical standards. But it may mark the beginning of the end.

"The Germans have received back again that measure of fire and steel which they have so often meted out to others. Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."
Winston Churchill following the victory at El Alamein, 10 November 1942.More of the same

"We shall never surrender!"
"We shall not flag or fail. We shall go on to the end. We shall fight in France, we shall fight on the seas and oceans, we shall fight with growing confidence and growing strength in the air. We shall defend our island, whatever the cost may be. We shall fight on the beaches, we shall fight on the landing-grounds, we shall fight in the fields and in the streets, we shall fight in the hills. We shall never surrender!"

Any excuse will do as markets continue to move on the expectation that global central banks don't have the cojones to withdraw liquidity, that is, to increase the cost of debt in our highly leveraged global financial systemMay 17, 2007 (iTulip)

The historical pattern of a 10-year rhythm of cyclical financial crisesThe 30% US market crash of 1987, in which investors lost 10% of 1987 GDP, was set off by the 1985 Plaza Accordto push down the Japanese yen with an aim of reducing the growing US trade deficit with Japan.
The 1987 crash was followed 10 years later by the Asian financial crisis of July 2, 1997
Henry C.K. Liu, Global Research, May 9, 2007

The Fed's stated goal is to cool an overheated economy sufficiently to keep inflation in check by raising short-term interest rates, but not so much as to provoke a recession. Yet in this age of finance and credit derivatives, the Fed's interest-rate policy no longer holds dictatorial command over the supply of liquidity in the economy. Virtual money created by structured finance has reduced all central banks to the status of mere players rather than key conductors of financial markets. The Fed now finds itself in a difficult position of being between a rock and a hard place, facing a liquidity boom that decouples rising equity markets from a slowing underlying economy that can easily turn toward stagflation, with slow growth accompanied by high inflation.

US consumer credit jumped in March. But the greater rise was in
revolving consumer credit, ie borrowing on credit cards at 13½-14½% interest.
This is not sustainable. Moreover, personal spending and car sales both
weakened in March. If that still needed a jump in borrowing to finance, then
the outlook when borrowing growth slows, is very bleak. (Gabriel Stein)

The last time stocks were setting records the way Wall Street is now was way back in March of 2000, and we all remember how that ended. A recession and a brutal bear market were just around the corner.
Chris Isidore, CNNMoney.com senior writer May 8 2007

That's why it's easy for some investors to be worried now, even with the Dow Jones industrial average on its best run in 80 years. At the same time the S&P 500, a broader measure of blue-chip stocks watched more closely by Wall Street pros, is nearing its record high as well.But while the stock market's partying, economic growth is the weakest it's been in four years. Two key parts of the economy - housing and auto sales - are already in recession. Home prices are posting historic declines and auto sales have been tanking. And another pillar of economic growth, business spending, has been weak.

We found 28 bubbles. Every one of the 28 went back to trend, no exceptions, no new eras, not a single one that we can find in history."Jeremy Grantham

Mild stagflation, predicted as the ultimate outcome of radical Fed easing in this column five years ago, is now here.
So, how does the market react to the bad news? By going higher, naturally. It has now been up 19 of the last 21 trading days. Amazing.John Mauldin, 27/4 2007

I believe US stocks are now very attractive for investors.
5 per cent real return on stocks still yields a 3 per cent premium over inflation-indexed bondsJeremy Siegel, FT, 26/4 2007

A real recession would quite likely end the current bear market in stocks, just as in 1974, when a recession arrived to put an end to a savage bear market.
It was a period, in its combination of economic slowdown and post-bubble financial meltdown,
with a striking resemblance to the bear market that started in 2007Jim Jubak CNBC 30/9 2008

The risk of a downward spiral of house prices is the primary danger facing the American economy.
Because of the structure of securitised mortgage finance, this risk has the potential to cause a global financial crisis.
Both of these problems will remain until a new policy brings stability to house prices.Martin Feldstein, Financial Times, August 26, 2008
Very Important Article

The prospect for the economy isn’t V-shaped, it’s L-ishWhen will it all end?
The answer is, probably not until 2010 or later. Barack Obama, take notice.PAUL KRUGMAN, NYT July 18, 2008

Case for an "L" Shaped RecessionNow that it's clear we are in a recession, the question has arisen as to what shape it will take:
"V", "U", "L", or "W".
Mish April 08, 2008

The current new consensus among macro forecasters and Wall Street firms is that the recession will be V-shaped, i.e. be short and shallow.
More likely to me is something like an "L" or a "WW" kind of scenario with the U.S. slipping in and out of recession for a prolonged period of time, perhaps 3-4 years or more.

"Downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further."
Ben Bernanke, testimony before the Senate Banking Committee, February 14, 2008

It it is far from obvious that we face a major worldwide recession.
Samuel Brittan, FT January 31 2008

One of the reasons I went into economics was a puzzle about involuntary unemployment: the paradox of unsatisfied wants side-by-side with idle hands. While there are enough genuine problems because of the scarcity of real resources to satisfy everything we should like to do, depressions associated with lack of spending are an unnecessary extra; and there are more than enough ways of stimulating citizens or governments to spend more.
It took John Maynard Keynes’ elaborate theory to persuade policymakers of the obvious.

A recession is a normal part of the business cycle.
It takes a major policy mistake by a government or central bank to create a depression.John Mauldin, February 2, 2008

If the US suffers a recession in 2008 or 2009 it will not be due to an industrial decline or an oil price shock. It will be a recession that began in the financial system.
The response of the general public is confusion, tinged with horror, at how intangible finance can impinge on their daily lives.Financial Times editorial January 25 2008

The issue here is not whether there is going to be a recession in the world or individual countries,
but what governments and central banks could do about it. There are many problems about policies to maintain activity,
but lack of policy instruments is not one of them.Samuel Brittan

The recent government report that US gross domestic product increased 0.6 per cent in the first quarter was very misleading.
Monthly data since January indicate that GDP have been declining since the start of this year.
Martin Feldstein, FT May 7 2008

Because US mortgages are “no-recourse” loans (lenders have no recourse to the house’s owner beyond the value of the house), individuals with negative equity have an incentive to default. There are now an estimated 8m negative-equity mortgages – more than 15 per cent of all outstanding mortgages. Defaults are rising and foreclosures are now at twice the rate of a year ago.

A downward spiral in house prices would cause a fall in household wealth and in the capital of financial institutions, potentially resulting in a deeper and longer recession than any seen in the past several decades.

Now is the time for policy action to forestall such a house price collapse.

A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.
Martin Feldstein, Wall Street Journal, February 20, 2008

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.

But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

Morgan Stanley has issued a full recession alert for the US economy,
warning of a sharp slowdown in business investment and a
"perfect storm" for consumers as the housing slump spreads.
Ambrose Evans-Pritchard, Daily Telegraph 12/12/2007

In a report "Recession Coming" released today, the bank's US team said the credit crunch had started to inflict serious damage on US companies.

Wake up to the dangers of a deepening crisis
The odds now favour a US recession that slows growth significantly on a global basis.
There is the risk that the adverse impacts will be felt for the rest of this decade and beyond.Lawrence Summers, FT November 25 2007

In 1929, days after the stockmarket crash, the Harvard Economic Society reassured its subscribers: “A severe depression is outside the range of probability”.
In a survey in March 2001, 95% of American economists said there would not be a recession, even though one had already started.

As you can clearly see from the chart, the LEI has been a very good indicator of recessions (gray areas) and well in advance. While there's no guarantee that it will always be so accurate,
it is not currently signaling that we are headed for a recession in the near future. Gary D. Halbert at John Mauldin 16/10 2007

The US consumer is on the precipice of experiencing the first recessionary phase since 1991
– the last time we had the combination of punishingly high energy prices, weakening employment, real estate deflation and tightening credit conditions.
Kronkursförsvaret var 1992David Rosenberg, chief North American economist for Merrill Lynch, FT November 14 2007

More easing by the Federal Reserve is likely. Much more. We would not be surprised to see Fed funds go as low as 2 per cent.Comment by Rolf Englund: Ahh, that is why he is writing this. That is what Merril Lynch wants now.

In the housing market, September was a watershed. Builders cut housing starts to a decade-low 1.19m (annualised rate), and there are still 4.4m unsold homes for sale, 16 per cent more than a year ago. This points to sustained deflation pressure and lower sales volumes. Housing starts could be forced as low as 800,000 to clear the market.
Housing is a $23,000bn asset class, but this market is going to be under pressure for years and the deepest retrenchment from the negative wealth effect has yet to be felt by consumers.

"The critical issue on the whole subprime, and by extension, the international financial system
rests very narrowly on getting rid of probably 200,000-300,000 excess units in inventory,"Alan Greenspan, CNN 2007-11-06

What masquerades as the sharing of risk is in fact a system malfunctioning, with the potential to undermine the integrity of the financial system. Sharing risk can under certain circumstances be inherently destabilising.
One person who would have had a field day with this discussion is Hyman Minsky, the US economist who died in 1996 and whose writings have recently enjoyed a renaissance.
One of his contributions is the financial instability hypothesis – a theory about the impact of debt on the financial system. In contrast to much of modern macroeconomics, Minsky treats banks and investors as the most important economic actors.Wolfgang Münchau, FT 23/4 2007

The Bank Credit Analyst's Latest Thinking
As you know, BCA has maintained all year that a recession was not the most likely scenario, and that the US economy could surprise on the upside. As usual, they were right on.
However, in their latest report for November, the editors take a more cautious stand in their outlook:

"The U.S. economy will be sluggish in the next few quarters as the housing downturn grinds on, consumers retrench and businesses remain reluctant to invest. It would not take much in the way of additional negative shocks to tip the economy into recession... Even though recession should be avoided, the outlook is fraught with uncertainty."

This language is definitely more cautionary than in previous months. This is primarily because the editors believe the housing slump is far from over, and I agree.
While their most likely scenario is that we avoid a recession, they are quick to add in this latest report that it is possible that housing woes could lead to a further slump in consumer confidence, and therefore spending, which could tip the economy into a mild recession sometime next year.
John Mauldin 2007-11-06

The only silver lining so far has been that these adjustments to the US currency have been orderly - declines in the broad dollar index averaging a little less than 4% per year since early 2002. Now, however, the possibility of a disorderly correction is rising - with potentially grave consequences for the American and global economy.
A key reason is the mounting risk of a recession in America.Stephen S. Roach 2007-10-22

The dollar has finally begun its long overdue correction.
Its recent decline is just a prelude to the much more substantial fall needed to shrink the US current account deficit
Martin Feldstein, FT October 15 2007

The United States Heads for Recession
Global Rebalancing
John H. Makin, American Enterprise Institute, September 26, 2007

First, as the Fed acknowledged on August 17 when it cut its discount rate from 100 basis points above the federal funds rate to just 50 basis points above it, "Financial market conditions have deteriorated and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward."

The second major event spurring the Fed's transformation from concerned about inflation to fighting recession was the annual late-summer economic symposium at Jackson Hole, Wyoming.

Two major themes emerged from the impressive set of research papers presented at Jackson Hole.
The first, featured in a paper by Edward Leamer of UCLA, reminded the participants--including Chairman Ben Bernanke--who listened carefully to all of the presentations that over the last half century every housing downturn comparable to the magnitude of the one currently underway in the United States has translated into a U.S. recession.
Another paper on housing and consumer behavior by John Muellbauer of Oxford University presented convincing evidence that it is credit market problems associated with housing weakness, not necessarily wealth losses, that can severely depress consumption.

The next six months will show how well the world economy and the U.S. economy can perform without a strong contribution from U.S. consumption growth.

The adjustment process--global rebalancing--will include continued dollar weakness and a fall in U.S. consumption, invariably a sufficient condition for a U.S. recession.

Spain's housing sector is due for a sharp correction.

The global economy is achieving a much-sought rebalancing away from dependence on U.S. demand growth and large U.S. trade deficits and toward more dependence on global demand growth and lower U.S. external deficits. That said, the process may not be as painless as some have imagined.

The dominoes are toppling.
What began as a credit crunch has turned into a dollar crunch. We are witnessing a run on the world's paramount reserve currency,
an event that occurs twice a century or so, and never with a benign outcome.
Ambrose Evans- Pritchard, Daily Telegraph 1/10 2007

The US dollar has fallen through parity against the Canadian dollar and
plummeted to all-time lows against a basket of currencies.
This is dangerous. None of the mature economic blocs seems able to take the strain, let alone step in to restore order.
Ultimately, Europe and Japan are in worse shape than the US.

Until now, the euro has served as the "anti-dollar", the default choice for Asians and petrodollar powers wary of US assets. This cannot last.
A rate of $1.43 (it was 83 cents in 2000) will combine, after a one-year lag,
with deflating property bubbles in the Club Med bloc to cause a crisis in 2008.
It will then become clear that the needs of the Germanic and Latin zones are incompatible and
that a coin with no treasury, debt union, or polity to back it up cannot displace the dollar — if it survives at all.

French President Nicolas Sarkozy is in guerrilla warfare against the ECB, threatening to invoke Maastricht Article 109, which gives EU politicians power to set a fixed exchange rate (by unanimity) or a "dirty float" (by majority).

am not sure that the Bernanke Fed will move fast enough, given fears of moral hazard, or, indeed, whether the rate cuts on offer are enough to head off an insolvency crisis. The chart of S&P 500 looks eerily similar to October 1987, the last time a tumbling US dollar set off a crash.

Let me cover the big picture.
I do think we're approaching the end of the world as we know it…I think there is such thing as the business cycle.
Doug Casey, september 26, 2007

It exists. And we've had the longest expansion - and the strongest expansion - in the world history. But we're at the end of a 25-year boom. It's gone on more than a full generation now. And I'll tell you how it's going to end: It's going to end with a depression, and not just a depression; not just another Great Depression; it's going to be the Greater Depression.

What's a depression, incidentally? It's a period of time when distortions and misallocations of capital are liquidated; that's called a depression.

Beware moral hazard fundamentalists
The world has at least as much to fear from a moral hazard fundamentalism
that precludes actions that would enhance confidence and stability
as it does from moral hazard itself.Lawrence Summers, Financial Times September 24 2007

Federal Reserve cut interest rates by an aggressive 50 basis points.If low interest rates cause foreign investors to lose confidence in the US currency
then the chance of recession in the world’s largest economy will rise.
Financial Times editorial 22/9 2007

What will worry Mr Bernanke is the rise in long-term interest rates – yields on Treasury bonds maturing in 10 or 30 years rose – and a sharp 1.5 per cent fall in the dollar’s effective exchange rate in the space of only a few days.

A decline in the dollar would be welcome if it was slow,
but if foreign investors anticipate inflation and start to dump some of their $12,000bn in US debt, it could turn into a rout.
In the worst case the Fed would lose some control of monetary policy, with long-term rates responding to foreign selling no matter what the Fed did at the short end,
and the economy plunged into recession.

Danger: Steep drop ahead
Even if the credit crunch passes without a major catastrophe,
the prices of stocks, bonds and real estate have a long way to fall.
By Jeremy Grantham, CNN/Fortune September 5 2007, 9:27 AM EDT

(Fortune Magazine) -- Credit crises have always been painful and unpredictable.
The current one is particularly hair-raising because it's occurring amid the first truly global bubble in asset pricing.

Recession? What Recession?
Only two recessions (1990-91 and 8 months in 2001) in the United States over the past 25 years;
over the previous 35 years there were eight.
Bob Pisani 24 Aug 2007

This "great moderation" of the economy has been explained many ways: luck, structural changes in the economy, etc., but in the end even the cautious NBER admits that improved policies on the part of those steering the economy are the likely reason we have avoided recessions:
"This hypothesis has obvious appeal. In our own work, we have found that monetary policymakers have been guided by a better understanding of the economy in recent decades and have largely avoided episodes where they first pursued expansionary policies that caused inflation to rise and then pursued extremely tight policies to bring inflation back down."

Over the past 20 years major financial disruptions have taken place roughly every three years
Financial crises differ in detail but, just as there are plot cycles common to literary tragedies, they follow a common arc.
Lawrence Summers, Financial Times August 27 2007

The 1987 stock market crash; the Savings & Loans collapse and credit crunch of the early 1990s; the 1994 Mexican crisis; the Asian financial crises of 1997 with the Russian and Long-Term Capital Management events of 1998; the bursting of the technology bubble in 2000; the potential disruptions of the payments system after the events of September 11 2001 and the deflationary scare in the credit markets in 2002 after the collapse of Enron.

Sure enough the problems of subprime mortgages – initially seen as a confined issue – went systemic as the market began to doubt the creditworthiness of even the strongest institutions and rushed to buy US Treasury debt.

First there is a period of overconfidence, rising asset values and growing leverage as investors increase their faith in strategies that have enjoyed a long run of success.

Second, there is a surprise that leads investors to seek greater safety. In the current case it was the discovery of huge problems in the subprime sector and the resulting loss of confidence in the ratings agencies.

Third, as investors rush for the exits, the focus of risk analysis shifts from fundamentals to investor behaviour. As some investors liquidate their assets, prices fall; others are in turn forced to liquidate, further driving prices down. The anticipation of cascading liquidations leads to more liquidations creating price movements that seemed inconceivable only a few weeks before. The reduced availability of credit then has a negative effect on the real economy.

Eventually – sometimes in a few months as in the US in 1987 and 1998; sometimes over a decade, as in Japan during the 1990s – there is enough price adjustment that extraordinary fear gives way to ordinary greed and the process of repair begins.

While it is too soon to draw policy lessons, we can highlight questions the crisis points up. Three stand out.
First, this crisis has been propelled by a loss of confidence in ratings agencies as large amounts of debt that had been very highly rated has proven very risky and headed towards default.
Second, how should policymakers address crises centred on non-financial institutions? A premise of the US financial system is that banks accept much closer supervision in return for access to the Federal Reserve’s payments system and discount window. The problem this time is not that banks lack capital or cannot fund themselves.
Third, what is the role for public authorities in supporting the flow of credit to the housing sector?

I am among the many with serious doubts about the wisdom of the government quasi-guarantees that supported the government-sponsored entities, Fannie Mae, the Federal National Mortgage Association, and Freddie Mac, the Federal Home Loan Mortgage Corp , as they have operated in the mortgage market. But surely if there is ever a moment when they should expand their activities it is now, when mortgage liquidity is drying up.

It is downright hilarious to hear so many now clamoring for the return of Fannie Mae and Freddie Mac to act as "white knights" to save a very troubled mortgage industry
when they're the ones that started it all about five years ago with the first tidal wave of mortgage backed securities and derivatives.Tim Iacono, August 9, 2007

The central banks have been forced to pump in billions of dollars to oil the wheels of lending.But what happened in previous financial crises, and what are the lessons for today?
BBC 26/8 2007

The Fed can indeed be accused of being a serial bubble-blower. But this is not because it has been managed by incompetents.
It is because it has been managed by competent people responding to exceptional circumstances.Martin Wolf, August 22 2007

The “core” U.S. economy is doing fine.
That is, if you exclude consumer spending, business capital goods spending and housing – almost 85% of U.S. real GDP – the outlook is rosy
inasmuch as exports will surely surge because of the strong economic growth in the rest of the world. Other than the fact that exports are only about 11-1/2% of real GDP, a record high, there are other problems with depending on the rest of the world to be America's economic locomotive.
Paul L Kasriel, at The Market Oracle, 14/5 2007

Speaking of households, even though they are cutting back on their real spending, they seem to be tapping their credit cards more now that their home ATMs are draining – i.e., home equity growth is slowing – and mortgage lenders are requiring more than a pulse to qualify for a loan. Chart 4 speaks to this point. Is this an act of desperation?

Economist Paul Kasriel at the Northern Trust has come up with a recession indicator that has called six consecutive recessions with no misses
and no false positives dating back to 1962. Michael Shedlock 30/3 2007

NASD - the brokerage regulator - said that the amount of debt that investors took on to buy securities, known as buying "on margin," had soared to a record $321.2 billion
That topped the previous record of $299.9 billion in March 2000, at the peak of the last bull market in stocks.
Margin debt has more than doubled from $141.3 billion in January 2003
Reuters, 10/4 2007

NASD has long served as the primary private-sector regulator of America's securities industry. We oversee the activities of nearly 5,100 brokerage firms, about 171,000 branch offices and more than 662,000 registered securities representatives. In addition, we provide outsourced regulatory products and services to a number of stock markets and exchanges.NASD Home page

Interest rate is just another word for price. It is the price to borrow money and its price is supposed to be determined exactly the same way as the price of any other commodity, product or service is - through the interaction of supply and demand.
However, unlike every other product, commodity or service, interest rates and money do not operate in a Free Market. Interest rates and the supply of money are manipulated (controlled) by the Fed.
They do this by controlling the amount (supply) of money that is available in the banking system through their Open Market Operations (buying & selling treasury bonds in the open market) and by changing their deposits that they hold with their individual member banks, directly affecting their reserves and thus their ability to lend.
They also increase the money supply the good old fashioned way, by printing it

Recession in 2007?
Greenspan's recession comment opened the floodgates for the use of the "r word."
John H. Makin, 21/3 2007

Currently, markets are expecting the Fed's Open Market Committee to cut the federal funds rate by a total of 50 basis points, to about 4.75 percent, by the end of this year.

Thus far, the Bernanke Fed has not been forced to confront a situation in which its goal to slow inflation conflicted with its desire to avoid a rapidly escalating chance of recession.

The awkward reality is that, at least in the past, the Fed has only been moved away from a conservative stance by extraordinary market volatility and attendant systemic risk that force the Fed to ease, as it did after the Long-Term Capital Management crisis in 1998 and during the deflation scare of 2002–03.

The strength of the Fed's desire to lower inflation may be tested by markets in coming months.

A brief recession may be a small price to pay to retain the low and stable inflation required for long-run, sustained growth and wealth creation.

Could it really have arrived? Are global stocks about to tank in an all consuming way? Indeed, is this the moment Albert Edwards has been waiting for since 1996?
Of course, Edwards is perhaps London’s best-known doom-monger when it comes to stocks. FT Alphaville Monday, March 5th, 2007

For Edwards, Dresdner Kleinwort’s notoriously bearish global strategist, this truly is the moment.

/His ‘Ice Age’ thesis is that the US market is locked into a long-term trend of declining p/es that could easily continue until the ratio reaches ten or lower. Factor in a possible recession – which could reduce earnings by around 20% – and he believes that the S&P could fall by about 40% from current - 04.08.2006 - levels./

Here’s what he told Dresdner clients this weekend:
“We believe the long and widely awaited equity correction is upon us. The sharp deterioration in the US economic dataflow should extend that loss below key support levels. We expect government bonds to be the safe haven, especially as risk assets generally are likely to suffer as the Yen carry trade now unwinds.”

Markets fall, sometimes very sharply.By 3:02 it had dropped to 12,089.02 – off more than 540 points for one of the worst days in history.
John Authers, FT Investment Editor, February 28 2007

When did the much-expected wave of risk aversion of 2007 finally break? It can be timed with precision. At 2:57 on Tuesday afternoon in New York, the Dow Jones Industrial Average stood at 12,346.33 – off about 2 per cent for a day on which traders had been spooked by 9 per cent falls in Chinese stock indices overnight.

Strategists at 12 of the biggest Wall Street firms agree that U.S. stocks will rally next year (2007).
The last time Wall Street unanimously predicted an advance for the S&P 500, in 2001,
preceded a 33 percent slump over the next two years.
The U.S. economy fell into recession and the Sept. 11 attacks battered financial markets.
Bloomberg 18/12 2006

Lou Dobbs - The War on the Middle Class - Book Introduction
George W. Bush claimed through two presidential campaigns that America has become the "ownership society." I couldn't agree more. America has become a society owned by corporations and a political system dominated by corporate and special interests, directed by elites who are hostile -- or at best indifferent to -- the interests of working men and women of the middle class and their families.November 20, 2006

Dr Kurt Richebächer:
Past recessions were all triggered by true monetary tightening, hitting both the economy and the markets.
The current economic downturn is unfolding against the backdrop of unmitigated monetary looseness

The Dow Jones Industrial Average, adjusted for inflation, is down 17 percent from its all-time high on January 14, 2000.
It would need to rise another 2,378 points to set a new record, adjusted for inflation.
Center on Budget and Policy Priorities, 5/10 2006

So why hasn’t IT happened yet?
Thus far the Fed has succeeded in playing Fire Chief and kept pouring
liquidity into the system.
But the Fed CAN NOT keep the money and credit spigots wide open indefinitely:
All they are doing is delaying the inevitable, not curing it. Aubie Baltin 20/9 2006

In a few years, the low bond yields of recent years will look like an anomaly rather than the norm.Globalisation is more likely to push real interest rates and inflation higher than lower in the next few years.Joachim Fels, FT, 21/9 2006
The writer is managing director and chief global fixed income economist at Morgan Stanley

The aging of the boomer generation should “severely cut U.S. stock values in the near future,”
reducing the P/E ratio of the S&P 500 index by more than half over the next decade.
MarketWatch 29 December 2014

That’s the bracingly bearish conclusion of a report published this month by three researchers at the Federal Reserve Bank of San Francisco—though the report relies heavily on a demographic metric that leaves lots of room for debate.

The more urgent question, in many economists’ minds, is whether the aging of the population will be a drag on economic growth overall,
as has already been a problem in Western Europe and Japan. That’s a serious issue—one tackled by MarketWatch retirement guru Robert Powell in a recent column.
But it’s one that the Fed paper, with its narrow focus on the M/O model, leaves for another time.

"Baby boomers with 80pc of UK wealth shouldn’t feel guilty about younger generations' problems"80 pc of the Britain's net personal wealth is owned by people aged over 50
while younger folk often have no savings, substantial debts and little hope of becoming homeowners any time soon.Daily Telegraph, December 24th, 2011

The baby boomers, those born between 1946 and 1970, were the richest, and largest, generation that the world has ever seen.
Unsurprisingly, they created a truly golden age for housing, auto sales and overall consumer demand.Mr Paul Hodges, Letter FT, 6 september 2011

Americans born between 1946 and 1964 are beginning to retire as the U.S. stock market is still recovering
from the financial crisis that began in 2007 with the collapse of the subprime-mortgage market.
Bloomberg 22 August 2011

The timing is “disconcerting” and, since stock prices have been closely tied to demographic trends in the past half century, “portends poorly for equity values,” adviser Zheng Liu and researcher Mark Spiegel wrote in a paper released by the bank today.

According to IMF calculations, the credit crunch, bank bailouts and recession only account for 14 per cent of the expected increase in Britain’s public debt burden. The remaining 86 per cent of the long-term fiscal pressure is caused by the growth of public spending on health, pensions and long-term care.
2020 the majority of the baby-boomers will be retired.
Anatole Kaletsky, The Times June 2, 2010

The book The Pinch by David Willetts, the Tory Minister for Universities, and its subtitle conveys his main message with his characteristic clarity and directness: “How the baby-boomers took their children’s future and why they should give it back.”

Mr Willetts shows how the overwhelming size of the baby boom generation, in comparison with the generations just before and after, allowed people born in the two decades after VE-Day not only to dominate culture, fashion and morality, but also to accumulate wealth, monopolise employment and housing and reduce social mobility for the next generation.

Nearing Retirement and Unemployed or Underemployed One of the groups seriously impacted by the great recession is the "pre retirement" generation - currently the "Baby Boomers" - the workers between the ages of 45 and 64.
CalculatedRisk 13/3 2010

The unemployment rate for these age groups hit an all time high during the great recession (highest since WWII).

Michael Winerip at the NY Times has a story about the plight of several "Boomers" who he has tracked for the last year: Time, It Turns Out, Isn’t on Their Side

As retiring Baby Boomers flee to safer investments, some analysts fear there will be too many stocks and too few investors. But, a lot depends on how many of the more than 70 million Boomers can really afford a more conservative investing style, as they try to recover from a lost decade for the stock marketCNBC 1 Feb 2010

Nearly half of the drop in household wealth since 2007 can be ascribed to a 48 percent plunge in homeowners' equity. And, though home equity has edged higher since the first quarter of 2009, it still remains in a range last seen in the second half of 1999. As recently as 2008, few expected homeowners’ equity to sink to levels last seen 10 years ago. The $6.2 trillion of homeowners’ equity in the third quarter of 2009 had sunk by $7.25 trillion from its $13.5 trillion zenith in the first quarter of 2006. Houseprices

About 27 percent of the household sector’s loss of wealth since 2007 stemmed from a $3.4 trillion, or 22.7 percent dive in the market value of stocks and mutual funds directly held by households. Boomers have fresh memories of how the market value of equities and mutual funds was down by an even deeper 44% from its 2007 level as recently as the first quarter of 2009. A 38 percent run-up by the market value of equities and mutual funds between the first and third quarters of 2009 quickly restored $3.2 trillion of household wealth.

The crisis and its impact on pension plans have focused attention on the baby boomers,typically 20-25 per cent of the populations of western economies,
who are now starting to head off into retirement.
George Magnus, FT August 13 2009

Since the boomers, and baby boomer women especially, were the backbone of the economic expansion of the last 25 years, we may lose a growth driver of great significance. Expected changes in the numbers of people of working age and of those over 65 underlie a unique shift in age structure that may result in weaker economic growth and growing financial stress for individuals and the state.

Although it is widely known that our Social Security and Medicare Programs are threatened by these demographic trends, there are many who believe that they have accumulated sufficient private wealth to fund their retirement.
But this may not be so. The same crisis that strikes the public pension programs can overwhelm private pensions as well. Since there will not be enough workers earning income, there will not be enough savings generated to purchase the assets the retirees must sell to finance their retirement.Jeremy Siegel, Wall Street Journal, September 20, 2006

The inter-generational clash between the interests of those who have already grabbed the rewards of postwar prosperity and the young people now expected to support them in retirement.Philip Stephens, Financial Times 20/2 2007

“Please, Proceed to the Nearest Exit,”
With such pretty pie charts predicting fair winds, they feel secure aboard the “USS Stocks for the Long Term,” chanting the “Buy-n-Hold” mantra should they ever feel a tinge of concern. Yet, when this modern marvel collides with the iceberg of science and history, the pain will cause them to begin searching for what went wrong.
Doug Wakefield, September 14, 2006

The reckless masters of "economic armageddon"?
There have been many books written about the financial crisis: What caused it, who’s to blame and how it could have – and should have – been preventedThis new one, “Reckless Endangerment: How Outsized Ambition, Greed and Corruption Led to Economic Armageddon,” lives up to its lengthy title and gets deep into the weeds of who did what, when and how.
In short, Gretchen Morgenson and Joshua Rosner name names and connect the dots.CNN 27 May 2011 with nice pic

Sales of new homes fell sharply in February after plummeting in
January.
The overhang of unsold homes jumped to a 17-year high of 8.1 months.
As long as this overhang remains, builders are unlikely to build more meaning
that the housing market correction has further to go.

This situation will
remain until prices of new homes fall in earnest or until the Fed begins to cut
interest rates.

The problem, as I laid it out in my March 9 column,
is that every day that goes by without letting the steam out of the global financial market -- brought to a boil by an excess of cheap capital and even cheaper debt - raises the odds of a financial market Armageddon.
Jim Jubak 13/3 2007

I say Armageddon is in the eye of the beholder. To me, if a 10% drop is a correction, a 30% fall in stock prices is Armageddon. And before you pooh-pooh that number as just another crash, remember that if Armageddon is driven by the debt markets, the damage would be worse on that side than in the stock market.

The United States, the world's biggest debtor, and
China, the world's biggest creditor, each passed major statistical milestones this month.
In the second quarter, the Commerce Department announced this month, the United States paid more to its foreign creditors than it took in from its overseas investments -- the first time that's happened in 91 years. The gap was relatively small, $2.5 billion for the quarter, when measured against a $13 trillion economy, but it was still a milestone.At the end of September, China's foreign-exchange reserves topped $1 trillion.
Jim Jubak, CNBC 30/9 2006

The NASDAQ is Crashing. Have You Noticed?
Since the NDX topped at 1,721 on May 8th, the NASDAQ 100 has crashed 15.94 percent. It is down nearly 18 percent since its January 11th top
by Robert McHugh July 30, 2006

In an attempt to avoid the consequences of the late-1990s stock mania, the Fed managed (after 13 rate cuts and several tax cuts) to precipitate a bubble in housing. That bubble, in my opinion, is a far more dangerous problem than the stock mania was, because of all the leverage involved
Bill Fleckenstein, CNBC 3/7 2006

The Federal Reserve precipitated, aided, abetted and cheered the largest (by dollar volume) stock mania in the history of the world. That mania exhausted itself in 2000. The exhaustion was not caused by the Fed tightening, contrary to what many folks believe, any more than the 1929 market break (and ensuing Great Depression) was caused by Fed tightening.
Manias end in exhaustion, though there are always coincident events surrounding the end of the move that get blamed for the decline. In both 2000 and 1929, higher interest rates were present, but they were not the cause. The preceding bubble was the cause of both the subsequent exhaustion and the ensuing bust.

In an attempt to avoid the consequences of the late-1990s stock mania, the Fed managed (after 13 rate cuts and several tax cuts) to precipitate a bubble in housing. That bubble, in my opinion, is a far more dangerous problem than the stock mania was, because of all the leverage involved -- and the damage that will eventually inflict on the financial system, in addition to consumers whose overspending ways will be throttled back as the housing mania unwinds.

Anything is possible in financial markets, but the probability that the plunge in asset prices that began just a month ago could really be over after such a short time — and with so little damage being done to personal fortunes and financial institutions — must surely be very small. Much more likely is that any recovery that may or may not develop in the next day or two will turn out to be a “dead cat bounce” — in market parlance a brief and illusory rebound, whose main effect is to lure over-eager investors back into the market and then quickly deprive them of their wealth.
Anatole Kaletsky, The Times 15/6 2006

"Dramatically lower interest rates 'transferred' the tech stock bubble to a real estate 'bubble,'
"The tide of liquidity further lifted all speculative boats, including small- and micro-cap stocks, commodities and emerging markets.""Hedge funds now number 9,500 and are managing $1.3 trillion," Sonders says. "Their time horizons are often measured in minutes, not months, quarters or years like traditional institutions."
Charles Schwab's chief investment strategist Liz Ann Sonders,
San Francisco Business Time 15/6 2006

If you're a true pessimist you know a rally like that which began on June 13 doesn't really change anything.It's just a trap, a fake to get you feeling good about stocks, so that the market can slam your portfolio again.
Jim Jubak, CNBC 16/6 2006

Pessimist's Scenario No. 1
Not much has changed. Despite all its saber-rattling, the Federal Reserve isn't really all that committed to fighting inflation to the death.

A depression is probably inevitable this time.
The only serious question in my mind is whether it will be essentially deflationary in nature, as it was the case in the U.S. in the 1930s, or inflationary like in Germany in the 1920s
Doug Casey, 13/6 2006

Is the Greater Depression really inevitable? How bad will it be? Is there another side to the argument? Can it be avoided?

I suppose it's not absolutely inevitable. Perhaps friendly aliens will land on the roof of the White House and present the government with a magic technology that can undo all the damage it's done. But we live in a world of cause and effect where actions have consequences. That being the case, I expect truly serious financial and economic trouble. And the government will make it vastly worse by trying to "do something" instead of recognizing itself as the cause and backing off. I don't see any way out.

What indicators should we watch for that might tell us it's about to get ugly?

Gold... Then there's the CPI itself--although I don't think it's very accurate, in that all the adjustments, exclusions, weightings and what-nots the government has insinuated into it over the years makes the CPI as much of a floating abstraction as the dollar itself. It's funny how the government plays with figures for fear of hurting confidence. They believe the economy rests mainly on confidence, which, ironically, in today's world, is true. Unfortunately, confidence can blow away like a pile of feathers in a windstorm--and we have a class-5 hurricane coming. If the economy were sound and people for some reason lost confidence, the currency and the banks would be unhurt, and the next day things would go back to normal. But that's not the world we live in. So, higher CPI numbers are another thing that could destroy confidence and supercharge the gold price. They're coming.

Higher interest rates, which we're already seeing, will inevitably burst the real estate bubble, which is floating on a sea of mostly adjustable-rate debt, a lot of it interest-only or even with negative amortization. Higher rates will also crush bonds and probably stocks. And they'll devastate the economy since everybody is deeply in debt. However, I feel the Fed will keep short-term rates--which are really the only ones they control--as low as possible for as long as possible. For one thing, they don't want a recession, which this time could snowball into the Greater Depression.

The biggest single problem, however, is that there are trillions of U.S. dollars outside of the U.S. Unlike Americans, foreigners have no reason to hold them. And at some point very soon, perhaps when the Fed finally hits the wall on its ability to raise rates, these overseas dollars are going to start flooding back home, while the products and titles to real wealth flow out of America. Therefore, when the trade deficit starts turning around--which most people will think is a good thing--that will be the real tip-off the game is over. Trillions coming back to the U.S. will skyrocket long-term interest rates and inflation. The dollar will go into freefall.

I think there is real potential for a 10% to 25% decline over the next six months -- with the harsher end of the spectrum the more likely.
We had bear markets in 1949, 1953, 1962, 1966, 1970, 1974, 1978, 1982, 1987, 1990, 1994, 1998 and 2002.
This is sort of like one of those easy math tests that schools give fifth-graders.
What is the next likely number in this series?
Jon Markman, CNBC, 31/5 2006

Today we look at a very interesting set of ideas proposed by one William R. White of the Monetary and Economic Department of the Bank of International Settlements (BIS).
Let's look at one paragraph in particular, which I am sure will show up in bearish commentary all over the world: "Should any or all of these series revert to their historical means, the sustainability of future global growth would also be open to question, perhaps leading to a deflationary rather than an inflationary outturn. To combine the two possibilities, the worst case scenario would be inflationary pressures, leading to a sharp tightening of policy, which in turn could precipitate a process of mean reversion in a number of markets simultaneously."
John Mauldin, 26/5 2006

We need a Plan B to curb the debt headwinds
An unsustainable level of private sector debt
is the main factor explaining the present severe downturn,
as well as many previous downturns in history. William White FT March 2 2010

Why have markets reached their exposed position? The answer is that success breeds excess.
This is the argument of a fascinating new paper from William White, economic adviser to the Bank for International Settlements.
Martin Wolf, Financial Times 24/5 2006

The longer the period of macroeconomic stability, the greater the underlying excesses in investment and borrowing are likely to become. What happened to Japan in the 1980s is an example of this danger.

High inflation did not precede the great depression of the 1930s, Japan’s lost decade in the 1990s or the emerging market crises in east Asia in 1997 and 1998. What preceded all these extreme events were credit-fuelled investment booms in an era of stable inflation.
This, argued Friedrich Hayek, the Austrian economist, in the 1930s, was also the cause of the great depression.

This approach disappeared from view in the environment of the 1950s and 1960s. But, argues Mr White, it is due for reconsideration.

Is price stability enough?
Working Papers No. 205, April 2006 by William R. White
The Bank for International Settlements (BIS) Go, go, go

Morris considers this to have been a fabulous achievement ... But Morris concedes that Volcker’s success formed the seed for today’s mess, because the new climate of stability left banks confident enough to crank up their leverage and risk-taking.Trillion Dollar Meltdown:
Easy Money, High Rollers, and the Great Credit Crash, by Charles R Morris
thought-provoking for experts and a readable primer for the laypersonReview by Gillian Tett, FT, September 23 2007

Portentous /Portent=Omen/ time but what does it all signify?
With reference to Shakespeare’s Julius CaesarAndrew Hill, Financial Times May 23 2006

The problem with portents is working out precisely what they portend. As Cicero points out in the first act of Shakespeare’s Julius Caesar, “men may construe things after their fashion”: interpreting signs to mean something quite different from – or even at odds with – reality. Only in retrospect is it possible to assess which omens really counted.

Here is Charles Mackay’s 19th century account, in his classic Extraordinary Popular Delusions and The Madness of Crowds, of how John Law’s Mississippi investment project seized the imagination of 18th century France, boosting a whole range of “asset classes”, from food to fine fabric: “For a time, while confidence lasted, an impetus was given to trade which could not fail to be beneficial. In Paris, especially, the good results were felt. Strangers flocked into the capital from every part, bent not only upon making money, but on spending it . . . New houses were built in every direction; an illusory prosperity shone over the land, and so dazzled the eyes of the whole nation that none could see the dark cloud on the horizon announcing the storm that was too rapidly approaching.”

Shakespeare’s frightened courtiers may not have known what it meant when they saw lions roaming the Capitol or horses eating each other. But they could be utterly confident they were not a harbinger of good news. Alas for modern market strategists, even that level of certainty is absent these days.

The market is gripped by two scares: an inflation scare and a dollar scare.
Of the two scares, investors should worry less about US inflation and more about the dollar (though the two are obviously related).
Financial Times editorial 20/5 2006

Even after the recent declines, world stock markets remain far above their 2003 lows. The FTSE 100 index is up 73 per cent, the S&P 500 58 per cent, the Eurotop 91 per cent and the Nikkei 112 per cent. It is too soon to say the bull market is over.

The dollar is a bigger concern. While a steady and broad-based decline of the kind seen in late April/early May is both necessary and desirable, it could give way to a dollar rout and higher US interest rates. Much depends on Asian central banks, whose intervention to support fixed exchange rates frustrated a decline in the dollar in the post-dotcom bubble period, and their counterparts in oil exporting countries.

The yen "carry trade" (borrowing in yen at low interest rates and investing in higher yielding assets), which helped boost all risky assets, is fading away as Japan's economy revives.

In one day in October 1987 the Dow fell 500 points, equivalent to 2,500 points today. Anyone predicting that now would be taken away in a van.
Tony Jackson, contributing editor, Financial Times 19/5 2006

So why had they kept on buying before? That at least is an easy one. What we have here is the Greater Fool Theory. This says that even though you are perfectly aware a thing is overvalued – copper, say, or shares in a fly-by-night oil explorer – you keep buying it anyway. Why? Because the thing is still going up. When the time comes, you will find a Greater Fool to take it off your hands. Until, of course, the music stops and the Greater Fool turns out to be you.

Paul Tucker, director of markets at the Bank of England, on Friday said the recent climate of ultra-low interest rates and low volatility might have prompted investors to become complacent about underlying risks in the financial market. In particular, an explosion in the use of structured financial products, such as credit derivatives, might have distorted market interest rates – and left investors mis-pricing risk, he said.
Financial Times 20/5 2006

The International Monetary Fund is in behind-the-scenes talks with the US, China and other major powers to arrange a series of top-level meetings about tackling imbalances in the global economy, as the dollar sell-off reverberates through financial markets.

At the IMF's Spring Meetings last month, its managing director, Rodrigo de Rato, was handed new responsibilities to carry out 'multilateral surveillance', assembling groups of relevant countries to discuss critical issues in the global economy. With the long-predicted dollar bear market sending ripples throughout the world, the IMF is keen to use its powers as soon as possible.

In The Stock Market's DaVinci Code by Jonathan Moreland, the topic of the Plunge Protection Team
is once again discussed by a somewhat mainstream financial writerTim Iacono, 14/3 2006

The US dollar suffered a severe sell-off on Friday, taking it to its
weakest level against a trade-weighted basket of currencies since
October 1997, in a tumble that helped to trigger falls across world
equity markets.The dollar ended at $1.293 to the euroFinancial Times May 12 2006

In March 1999 as the stock market was in the last phase of a massive speculative bubble, James Glassman and Kevin Hassett of the American Enterprise Institute wrote a provocative column in the Wall Street Journal entitled "Stock prices are still far too low." The arguments in this piece were then reprised in a voluminous article in the September 1999 issue of the Atlantic Monthly and entitled "Dow 36,000." Finally in November 2000 as the stock market was beginning its precipitous descent, they unveiled their book "Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market."

As two distinguished financial economists, John Campbell of Harvard and Robert Shiller of Yale, have shown,
returns demonstrate “negative serial correlation”.* They revert to average valuations.
Martin Wolf, Financial Times 22/3 2006

Valuations are not as crazy as they were in 2000. But they still remain very high.

In the case of the US market, two similar measures of fundamental value – “q”, or the valuation ratio (the ratio of stock market value to the replacement cost of corporate capital), and the cyclically adjusted ratio of prices to earnings – continue to show exceptionally high values by historical standards.

Real returns have recently been extraordinarily high in the following stock markets: Australia, Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the UK and the US.

The fact that every asset price is high strongly suggests that the aggressive post-bubble monetary expansion explains today’s strong equity prices. Safe bonds, risky bonds, equities, gold, property and commodities are all expensive by historical standards. It is as if markets are expecting both inflation and deflation. That is not as irrational as it may seem. When asset prices are out of line with incomes, one of two things is likely: asset prices may collapse (which is deflationary) or incomes may soar (which means inflation). Markets are betting on both extremes.

Contrarians At The Gate One of the challenges of investing is when to move with the crowd and when to move against it. While it's taken as common wisdom that contrarian investing (placing trades that are on the opposite side of the "crowd") is a profitable strategy in the long run, the historical evidence suggests that a persistently contrarian approach - jumping on the contrarian bandwagon, so to speak - isn't always optimal.
John P. Hussman, Ph.D. January 23, 2006

The January issue of Science includes an article on bounded rationality in economic games, and has interesting implications about contrary investing. Economists Colin Camerer and Ernst Fehr explain that "strategies are complements if agents have an incentive to match the strategies of other players. Strategies are substitutes if agents have an incentive to do the opposite of what the other players are doing." (For some reason, we economists like to call normal people "agents"... we tend to call agents "spies").

Selling panic closes Tokyo marketTokyo's stock exchange closed early for the first time ever on Wednesday, as market bosses attempted to head-off a meltdown after a frantic day's trading.
BBC 18/1 2006

The causes of Germany’s fundamental economic weakness are still there. There are several conventional explanations, none of which is fully convincing.
The consensus among central bankers is that failure to reform labour markets has depressed the trend growth rate, which may now be as little as 1 per cent a year.
Switzerland has been a model of a deregulated, low-tax economy. Yet its average growth rate since 1991 has been 1.1 per cent.
Wolfgang Munchau, Financial Times, January 16 2006

“Foreseeing change in the conventional basis of valuation” is the cat’s meow of professional investment management.This is not a new game. Indeed, none other than John Maynard Keynes described the game beautifully in Chapter 12 of the General Theory:
Paul McCulley, Pimco, January 2006

“It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investors, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing change in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps,’ but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.”

20 Triggers for the Coming CollapseThere's an 86% probability that America will collapse into a major economic recession
Richard Rainwater is No. 112 on the Forbes 400 list of America's richest, worth $2.3 billion made in oil and real estateFox News 10/1 2006

What could go wrong and, more important, whether the risks of its doing so are adequately priced. They are not.On a cyclically adjusted basis, the US stock market is as highly valued as in any period of the past 120 years, except the late 1920s and the late 1990s.
Martin Wolf 3/1 2006

The biggest non-economic risks are those relating to security, as Harvard’s Ken Rogoff pointed out in yesterday’s FT.

According to the US Energy Information Administration, the total energy supplied by oil, natural gas and coal will need to grow by about three-fifths between 2002 and 2025.

The economic risks are most evident in today’s “imbalances”.

The principal domestic counterpart to the huge US current account deficit is the financial deficit of US households, currently running at an all-time record of more than 7 per cent of gross domestic product.

As Wynne Godley, the Cambridge economist, has pointed out, with such a financial deficit, the indebtedness of the household sector must rise continuously. And indeed it has, from 92 per cent of disposable income in the first quarter of 1998 to 126 per cent in the third quarter of last year. That rise in indebtedness has pushed household debt services payments to an all-time high of 14 per cent of disposable incomes, despite today’s modest interest rates.

What would happen if house prices ceased to rise or interest rates increased? Households would cut back on their borrowing. If they did, how would a sharp US slowdown be avoided?

The big question, however, is whether these risks are correctly priced. The reason to believe they might not be is our natural tendency to ignore the likelihood of low probability events, however calamitous. Nassim Taleb made this point in his brilliant book, Fooled by Randomness*. In a “Taleb distribution”, catastrophic loss follows a long history of small gains. Lulled into a sense of security, people greatly overestimate the probability of winning in the long run.

After such a long period of stable growth and low inflation, precisely this mistake seems evident in almost every asset market.

On a cyclically adjusted basis, the US stock market is as highly valued as in any period of the past 120 years, except the late 1920s and the late 1990s

I am neither clever enough nor foolhardy enough to make forecasts. It may be more likely than not that this year will be very like 2005.

The unaffordability of housing in the early 1980's led to an epic collapse in the housing industry. ... And ... was one of the main factors in the worst economic slump since the Great Depression, which brought the unemployment rate to a peak of 10.8 percent at the end of 1982.
Paul Krugman New York Times January 2, 2006
cit at economistsview

What if Pharaoh had beheaded Joseph for daring to suggest higher taxes during the fat harvest years so people would not starve during the lean ones? Instead, Egypt’s leader cast his lot with the world’s first recorded business cycle theorist and the rest is, well, history. But are our leaders today preparing for the inevitable downside of the cycle? I wonder.
Kenneth Rogoff, Financial Times, January 2 2006
The writer is professor of economics at Harvard University and former chief economist at the International Monetary Fund

It does not take a prophet to think of things that might go wrong.

The number one risk to global growth over the next few years has to be the global security situation, particularly a terrorist incident involving weapons of mass destruction.

As good as the economic fundamentals are, it is easy to find more down-to-earth vulnerabilities. Top of the list has to be global housing prices – which are not actually all that close to earth any more. With US prices up 60 per cent since 2000 and even higher price inflation in many other countries it is not hard to imagine a collapse, especially in frenzied regional markets such as California – which, after all, still has a larger economy than China’s.

Speaking of China, the leadership there still faces a delicate social, economic and political balancing act to sustain the country’s break-neck development pace.

Then there is energy. Yes, the run-up in oil prices over the past two years seems to have had a relatively modest effect on global growth. This was actually in line with most academic assessments, which suggest that at least half the perceived damage from pre-1985 oil shocks was due to monetary policy mistakes.

Lastly, the global financial system, while fundamentally a source of strength, is also a source of weakness. The explosion of unregulated hedge funds and the widespread use of derivatives...

To listen to the Bears over the past few years, you would have thought we would all be in breadlines and soup kitchens by now. Why Hasn't "IT" Happened Yet?
Even though the markets, at their lows in March of 2003 had lost over $6 trillion of value, IT still hasn't happened yet.
Aubie Baltin 27/12 2005

So far, all of the ranting about doom and gloom sounds more like the boy who cried wolf than accurate forecasting. But I do believe that when IT happens, things are going to get much worse than anyone can imagine.

If there is any doubt that the world's investment community is suffering from irrational exuberance, just look at the German and French Stock Markets; in the face of 12% unemployment rates and less than 1% growth rates to look forward to unemployment rates can only get worse and yet their Markets are making new five year highs just as Paris is burning after two solid week of Muslim rioting.

Fed would like to see a little inflation come back, as well as significantly higher interest rates, before they have to deal with the next recession or slowdown.
It would not be politically correct to state they intend to stop the increase in housing prices.
John Mauldin, 21/10 2005

Back in the dark ages, or around five years ago, Fed rates were at 6.25%.

The Fed would like to get some more "bullets" in their gun, a bullet being a 25 basis point increase in rates. It is just a matter of time until they will need their bullets, and as we saw last time, you may need more than you think.

Third, they are concerned about inflation. But not that much. If they were really concerned, they would have been raising rates at a much faster clip. They would be throwing in a 50 basis point increase very now and then. But in fact, I think they are happy to see a "little" inflation. It gives them cover to keep raising rates for real reasons #1 and #2.
It would not be politically correct to state they intend to stop the increase in housing prices. There would be lynch mobs forming. So "fighting inflation" is a nice cover.

WHY THE FED HAS NO OTHER ALTERNATIVE BUT TO PRINT MONEY!Why is the US Fed so concerned about deflation that Mr. Bernanke even suggested dropping US dollar bills from a helicopter in order to combat it?
There is one condition under which deflation is a disaster and this is when total credit market debt is high as a percentage of the economy
Marc Faber, October 18, 2005

How do we get out of this scenario alive?
By Rolf Englund, Financial Times 4/10 2005
Clyde Prestowitz, like many other commentators, warns us of what could happen: "a decline in the dollar, a rise in interest rates, a slowdown in growth, a rise in unemployment and declining home equity and household wealth - in a word, a recession, if not a depression"

I suspect the stock of outstanding synthetic credit derivatives - $ 1500 b in synthetic CDOs in 2004 v. $300 b or so in 2001, is the only thing than has increased more rapidly than China's reserves over the past few years.
China's reserves are probably above $800b now, up from $165b in 2000.
Brad Setser 18/9 2005

Kahneman Shiller The past decade has been a triumph for behavioural economics,
the fashionable cross-breed of psychology and economics.
Tim Harford, FT 21 March 2014

So popular is the field that behavioural economics is now often misapplied as a catch-all term to refer to almost anything that’s cool in popular social science

As with any success story, the backlash has begun.
Critics argue that the field is overhyped, trivial, unreliable, a smokescreen for bad policy, an intellectual dead-end – or possibly all of the above.

Is behavioural economics doomed to reflect the limitations of its intellectual parents, psychology and economics?
Or can it build on their strengths and offer a powerful set of tools for policy makers and academics alike?

behavioral economics
The threat was that of a paradigm shift. This term, coined by philosopher Thomas Kuhn, refers to the dread moment when scientists learn that up is down, black is white and everything they thought they understood about the world is wrong.Noah Smith Bloomberg 1 June 2015

Is Economics a Science?
– I am one of the winners of this year’s Nobel Memorial Prize in Economic Sciences,
which makes me acutely aware of criticism of the prize by those who claim that economics
– unlike chemistry, physics, or medicine, for which Nobel Prizes are also awarded – is not a science. Are they right?
Robert J. Shiller, Project Syndicate, 6 November 2013

The Nobel Prize in economics in 2002 went to a psychologist, Dr. Daniel Kahneman, who helped pioneer the field of behavioral finance. He basically shows that investors are irrational.
But what gets him a Nobel is he shows that we are predictably irrational.
We continue to make the same mistakes over and over.
John Mauldin, 26/8 2005

What makes for a bubble? Why do things get so out of hand? One of the reasons is simply human behavioral psychology. The longer a trend is in place the more confident we are in our belief that it will continue. Especially if we are participating in the trend to our benefit, we find all sorts of reasons that reinforce our belief that the trend will continue.

The runaway budget deficits are compounded by the persistent and growing imbalance in our trade accounts -- jeopardizing the inflow of foreign funds we have used to finance our debt.At a private dinner the other evening where many of the men and women who have steered economic and fiscal policy during the past two decades were expressing their alarm about this situation, one speaker summarized the feelings of the group:"I think it's 1925," he said, "and we're headed for 1929."
David S. Broder, Washington Post 11/9 2005

Even the unflappable Bank for International Settlements (BIS) seems uneasy. In its quarterly report released on Monday September 5th, it gives warning that “the complexity of some products and the associated risk-management systems, the growing presence of leveraged players in credit markets and the possibility that investment strategies may be less diverse than anticipated make it difficult to predict how credit markets will function under more stressful conditions.”
IMF’s economic counsellor, Raghuram Rajan: While recent changes in the financial system have made it more stable most of the time, they may also have increased the possibility that it will be excessively unstable in really bad times, as well as increasing the chances that really bad times will occur. We will not know how big the risks are, or what to do to mitigate them, until the system has been tested. “The danger,” he writes, “is that before the economy is stress-tested, it will be hit unexpectedly by a perfect storm.”
Buttonwood, The Economist 6/9 2005

Banks now securitise and flog to third parties their plain vanilla mortgages, keeping on their books the more complicated and less liquid assets that are harder to sell. When interest rates spike upwards, asset prices crash or for any other reason lots of investments have to be unwound in a hurry, banks may be looking for liquidity rather than supplying it to others to keep markets orderly.

We recently marked the fifth anniversary of the peak of the great millennial stock market Bubble. From the March 2000 top to the October 2002 trough, the U.S. stock market gave up more than half of its value, some $9.2 trillion.
Aubie Baltin, august 2005

Five years ago Cisco Systems was the world's biggest company by market capitalization. Its line of business, computer networking, was universally heralded as the industry of the future. Owners of Cisco still devoutly believe this still to be true. Never the less they have lost 75 percent of their investment.

Alan Greenspan, the chairman of the Fed, had worried about a stock market bubble as early as 1995 and had warned against "irrational exuberance" in 1996, and batted around the possibility that there might, indeed, be a stock-market bubble in discussions with his Federal Reserve colleagues as late as 1999. But he was not the man to stick a pin in the bubble.
Indeed, he himself became a vociferous booster of the "New Economy." In a speech he gave only four days before the Nasdaq touched its high, he sounded as if he were working for Merrill Lynch, cheering that "the capital spending boom is still going strong."

By 2006 we should be in recession and the Republican will lose at least one of if not both the houses of Congress and by 2008 the USA will be in depression and Hillary will win in a landslide and become the FDR of the 21st Century.

Investors recently had expressed optimism - some disbelief - that the market had stood face to face with record crude-oil prices and barely blinked.This week, however, the market didn't just blink; it fell to pieces as the Dow Jones Industrial Average shed 325.23 points, or 3.1%.
Blue chips fell each day this week, most of the losses coming Thursday and Friday.
Wall Street Journal 24/6 2005

I am going to write here about a coming depression in general terms. I have some suggestions for how to prepare, (as if anyone can).There are two types of depressions, hyperinflationary and deflationary.
The end results are the same.
Chris Laird Gold Eagle May 15 2005

First, the main thing the logistics equations suggest is that when the economic system becomes unstable, it is not possible to determine the outcome.

Remember the stock market bubble? With everything that's happened since 2000, it feels like ancient history. But a few pessimists, notably Stephen Roach of Morgan Stanley, argue that we have not yet paid the price for our past excesses.I've never fully accepted that view. But looking at the housing market, I'm starting to reconsider.
In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another.Paul Krugman New York Times 27/5 2005

As Boomers Retire, a Debate:
Will Stock Prices Get Crushed?In speeches and a new book, he is warning that a flood of boomer retirees with trillions of dollars of assets to sell over the next 20 to 40 years threatens to crush stock and bond prices.
Jeremy Siegel, the Wharton School finance professor well-known until now for recommending stocks as a long-term investment.
Wall Street Journal 5/5 2005

Prof. Siegel, 59 years old, was born in November 1945, just before the baby boom started in 1946. As a child, he delighted in charting the number of morning glories in his backyard. Thus began a lifelong passion in explaining and predicting trends, including the stock market. He earned his economics Ph.D. at the Massachusetts Institute of Technology and has taught at Wharton since 1976.

His 1994 book, "Stocks for the Long Run," came just as the bull market was switching into high gear, turning him into a sought-after stock-market guru. Prof. Siegel used historical data going back to 1802 to argue that stocks have consistently been better investments than bonds. The book sold more than 350,000 copies and was translated into eight foreign languages. His reputation got another lift in 2000 when he warned that technology stocks were overpriced just as the tech bubble was about to burst.

In 1935, average 65-year-olds worked until they were 69 and were dead before they were 77. Today, the average worker retires at 62 and can expect to live another 20 years. And the number of retirees will start surging in a few years when the first big chunk of the 1946-64 baby-boom generation retires.

The cumulative gap between what retirees would need to keep 90% of their standard of living and what they'll actually get -- given all those assumptions -- is about $123 trillion between now and 2050, the model suggests. That's the U.S. figure; if the same calculation includes Japan, Europe and other industrialized regions, the gap rises to $347 trillion.

The Future for Investors: Why the Tried and the True Triumphs Over the Bold and the Newat Amazon

I am not a believer in conspiracy theories. But In all my years in this business, never before have I seen a central bank attempt to spin the debate as America's Federal Reserve has over the past six or seven years.
From the New Paradigm mantra of the late 1990s to today's new theories of the current-account adjustment, the US central bank has led the charge in attempting to rewrite conventional macroeconomics and in making an effort to convince market participants of the wisdom of its revisionist theories
It is a concentrated effort on the part of the Fed to exonerate itself from the Original Sin of failing to address asset bubbles. The result is an ever-deepening moral hazard dilemma that poses grave threats to financial markets. Stephen Roach - Morgan Stanley Global Economic Team - April 25, 2005

The Great Transition Part I: Giant Popping SoundDid you hear it last week? I mean the Giant Popping Sound of the largest financial mania in history
another step along the way in the ongoing, seismic readjustment that it taking place in the global social, economic and political order.M.A. Nystrom 18 April 2005

Did you hear it last week? I mean the Giant Popping Sound of the largest financial mania in history as it continues to deflate, ripping through stocks and markets across the globe.

The Giant Popping Sound last week was actually just another step along the way in the ongoing, seismic readjustment that it taking place in the global social, economic and political order.

Peter Drucker describes it quite bluntly in the introduction to his book, "Post-Capitalist Society:
"Every few hundred years in Western Civilization, there occurs a sharp transformation. . . Within a few short decades, society rearranges itself - its worldview; its basic values; its social and political structure; its arts; its key institutions. Fifty years later, there is a new world, and the people born can't even imagine the world in which their grandparents live and into which their own parents were born.

Last bubble was brief, but still irrationalShort duration does not necessarily mean small magnitude.
The size of the late 1990s stock market bubble at its peak still supports a very pessimistic reading of stock market rationality.By Brad de Long and Konstantin Magin Financial Times 18/4 2005

Brad DeLong is professor of economics at the University of California, Berkeley, and Konstanin Magin is a post-doctoral fellow at the Center of Integrated Nanomechanical Systems

Nasdaq Composite index exploded in late 1999, more than doubling in value in the year up to its late-winter 2000 peak, and the huge bath taken by investors in the Nasdaq from February 2000 to September 2002 as the index lost three-quarters of its value.

It is next to impossible to interpret these events within the context of a rational-expectations model, in which stock prices provide the best possible forecasts of future values. Only those who want their colleagues to doubt their own rationality even try.

By the end of 1996, Alan Greenspan, chairman of the US Federal Reserve, was worrying about the stock market. "How do we know," he asked an audience at the American Enterprise Institute, the Washington think-tank, "when irrational exuberance has unduly escalated asset values?" If you had invested in the Nasdaq while Mr Greenspan was writing his speech, you would have realised a real return from then until now of 8.1 per cent per year.
The answer to the question Mr Greenspan implied in December 1996 - "Are asset prices unduly escalated by irrational exuberance?" - is no.

Today many people - including us - are worried about high levels of bond prices and real estate in the US and elsewhere that seem incompatible with likely scenarios for the world economy. This look back at the bubble of the 1990s is somewhat reassuring: financial markets were not as dumb as we feared then, and so are probably not as dumb as we fear now. Like the late 1990s, any bond or real-estate bubble this decade will probably be of short duration.

However, short duration does not necessarily mean small magnitude. The size of the late 1990s stock market bubble at its peak still supports a very pessimistic reading of stock market rationality.

Paul A. Volcker:there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will.
Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot.
What really concerns me is that there seems to be so little willingness or capacity to do much about it.Washington Post April 10 2005

We sit here absorbed in a debate about how to maintain Social Security -- and, more important, Medicare -- when the baby boomers retire. But right now, those same boomers are spending like there's no tomorrow. If we can believe the numbers, personal savings in the United States have practically disappeared

Richard Clarida in Wall Street JournalAlan Greenspan stirred up the bond market by opining that the then-low level of bond yields -- in tandem with strong growth, $50 oil
and a succession of Fed rate hikes since June -- represented a "conundrum."
From the TIPS market, we learn that the expected real return over the next 10 years on a riskless investment in government bonds is 1.81%.11/4 2005

Mr. Clarida, professor of economics at Columbia and economic strategist at the Clinton Group, is a former assistant Treasury secretary in the Bush White House.

From the TIPS market, we learn that the expected real return over the next 10 years on a riskless investment in government bonds is 1.81%. This compares with an average of 3.1% over the past eight years, and a level of 2.86% in October 2001 when the economy was still in recession and prospects for economic growth were sure not as buoyant as they are today. Monetary economics and practical experience teach us that the Fed has limited ability to adjust the long-term average real rate. Instead, the expected long-term average real rate is determined in the global capital market.

The real puzzle is why required real rates of return are unusually low in the U.S. and abroad (as confirmed, for example, by the inflation-indexed yield of 1.8% offered in the U.K. government bond market).

The answer is that we are to some extent still in a post-bubble world, in which there is an excess of global saving compared with perceived profitable global investment opportunities.

I believe the U.S. will run a structural current-account deficit of 2% to 3% of GDP even after this adjustment is completed.

The World Bank;The severity of the coming slowdown will depend on the extent to which foreign investors lose their nerve about buying U.S.-dollar-denominated assets.
"A reduction in the pace at which central banks are accumulating dollars, a weakening in investors' appetite for risk, or a greater-than-anticipated pickup in inflationary pressures could cause interest rates to rise farther than projected, providing a deeper-than-expected slowdown or even a global recession
Wall Street Journal 6/4 2005

In an annual report on the risks confronting developing economies, the bank said the global recovery of the last three years has masked cracks that can't be left unattended for much longer.

The bank said, a new global recession is a possibility.
"A reduction in the pace at which central banks are accumulating dollars, a weakening in investors' appetite for risk, or a greater-than-anticipated pickup in inflationary pressures could cause interest rates to rise farther than projected, providing a deeper-than-expected slowdown or even a global recession," it said.

– Welcome to the Bubble Economy, 2005.There’s the housing bubble and the commercial office space bubble. There’s the bond-market bubble and its two progeny, the junk-market bubble and the emerging-market-debt bubble. That nearly $2.50-a-gallon price you see at the pump has all the markings of an oil bubble. And the premiums being paid for all those corporate mergers and acquisitions is a pretty good indication of a stock-market bubble.
Steven Pearlstein 5/4 2005

In fact, nearly every asset market you can think of is showing signs of bubblelike behavior. The reason is pretty clear: The global economy is awash in free cash.
“There is an excess of liquidity around, and it is proving very hard to get rid of it,” said John Makin of the American Enterprise Institute, using the term preferred by economists.

Fed maestro Alan Greenspan has argued that nobody can really identify a financial bubble until after it has popped, which was one reason the Fed did little to try to prick the stock market bubble in the late 1990s. That sophistry was exposed last month when transcripts of Fed meetings from 1999 were released showing that Fed officials, including Greenspan, were quite aware that they were dealing with a bubble of immense proportions.

A bubble or mania is a type of investing phenomenon that occurs when investors put too much demand on a stock or sector.
A crash is a sudden, dramatic drop in value of individual shares of stock and the total stock market as a whole. It generally occurs in a very short period of time. It is attributable to the bursting of a bubble.
Rich Scott & Ramsay Simmons March 2005

We will look at three examples of historic speculative bubbles: the Dutch Tulip Mania (1634-1638), the South Sea Bubble (1720), and the Bull Market of the Roaring Twenties (1924-1929).

Five years to the day after the peak of the last global investment bubble, signs that another one may be about to burst could be seen, ironically enough, in the telecommunications industry.
Chuck Prince, chief executive of Citigroup, said: "The possibility of a liquidity bubble around the world concerns me. A very cautionary thing is that it feels like the world is changing and traditional indices may not give a complete picture."
Financial Times 14/3 2005

For much of the last two years, a credit boom has encouraged a flurry of highly-leveraged takeovers and allowed the refinancing of dozens of troubled companies. In Europe and the US, more than $100bn of so-called "high-yield" debt has been sold in the last eight months alone at barely half the premium over bank rates issuers were forced to pay in 2002.

Many of the biggest players in the debt market are reluctant to express their worries in public but privately admit to deep concern. The chief risk officer at a leading Wall Street firm says banks are being forced to lend on aggressive terms to "stay in the game", even though they know trouble is being stored up. "It's like a game of musical chairs. You just hope it is somebody else that gets hurt when the music stops."

The head of one of the biggest commercial lenders in the US describes the amount of leverage on some buy-out deals as "nutty". Much of the wildest lending is being done by hedge funds awash with cash, he says. "Some funds believe they have to invest the money even if it's not a smart investment. They think the people that gave them the money expect them to invest it. But it's madness." He concedes that it is difficult to predict when the market will turn - "it could stay frothy for some time" - but believes the catalyst is likely to be not an increase in interest rates but a large financing transaction that fails to get executed.

One of my deepest concerns is that the current complacency with the trade deficit which stems from the relative stability of the US economy and markets will lead to an event as dramatic as the fall of the NASDAQ.
The US economy is growing handily, thank you very much, and unemployment is slowly beginning to drop. The trade deficit has caused no problems.John Mauldin 11/3 2005

When the Federal Reserve raises interest rates, trouble usually follows.
In 1987, the stock market crashed. In 1994, Orange County went bankrupt and Mexico devalued its peso, ravaging its economy. In 2000, the Nasdaq Stock Market bubble burst.
Others think it will be different this time.
Wall Street Journal 20/3 2005

Bubbles were once very rare—one every hundred years or so was enough
Nowadays we barely pause between such bouts of insanity.
The dot-com crash of the early 2000s should have been followed by decades of soul-searching; instead, even before the old bubble had fully deflated, a new mania began to take hold on the foundation of our long-standing American faith that the wide expansion of home ownership can produce social harmony and national economic well-being.
Eric Janszen, Harpers Magazine February 2008

The new economy belonged to finance, insurance, and real estate—FIRE. FIRE is a credit-financed, asset-price-inflation machine organized around one tenet: that the value of one’s assets, which used to fluctuate in response to the business cycle and the financial markets, now goes in only one direction, up, with no more than occasional short-term reversals.

"Eight hundred years of financial folly"
Carmen Reinhart has provided a synopsis of a paper she did with Kenneth Rogoff looking at financial crises over a longer time frame than most analyses, which have limited themselves to recent history
Naked Capitalism, April 20, 2008

Although the new paper is descriptive, the implications are not pretty for the US. Recurrent financial crises are the norm; it seems that countries get drunk regularly on too much capital inflows, go bust, sober up, and fall off the wagon again. In fairness, individual countries aren't necessarily recidivists, but the financiers and policymakers, who ought to know better, instead rationalize that each time that current circumstances differ from the not-too-distant past.

Ed Hyman reminded us that every Fed tightening cycle has brought a financial crisis. Here is his list.Chad Hudson March 2, 2005

Fed Tightening Cycle

Financial Crisis

1970

Penn Central

1974

Franklin National

1980

First Penn / Latin America

1984

Continental Illinois

1987

Black Monday

1990

S&L Crisis

1994

Mexico

1997

Pac Rim / Russia / LTCM

2000

NASDAQ

RE: The best book I have ever read
In my book The Shifts and the Shocks, I argue that pre-crisis trends
– huge global current account imbalances, rising inequality and weak propensity to invest –
had already created weak underlying demand in high-income countries.

The de facto response of policy makers was toleration, if not promotion, of credit booms.

When these collapsed, extraordinary policy easing was needed both to replace the lost demand impetus from the credit bubbles and to
offset the drag on demand from debt overhangs, predominantly in private sectors:

Let me be clear about what I think Roach is saying but cannot say directly.
He is referring to the "R" word - Recession.
Rates that would be high enough to slow (compress) consumer demand must be high enough to raise borrowing costs. They must be high enough to significantly slow down home equity loans for new consumption. John Mauldin
March 4, 2005

That will mean lower new home construction, a slower real estate market and thus slower increases or even (gasp) a fall in home values, and slower or no increases in consumer spending growth. Reduced home construction and falling ("compression" sounds so much gentler than falling!) consumer spending. In short, a recession.The mirror of the recession of a few years ago, when housing and consumer spending did not stop their growth, and the brunt of the pain fell on business. During the last recession we had falling rates and massive stimulus.Far be it from me to quibble with Roach, who is far smarter than I am, but again, I am not certain that this is the complete picture. I think there is more to it than a falling dollar and interest rates.

The fact is that the US consumer is in pretty good shape on an individual basis, or at least thinks he is. Our national wealth and income are at all time highs. Our ability to service our debt is well within our income. While "savings" are not growing, we are in fact saving in our pensions and homes and stocks, which do not count in the national savings rate. If this were not true, we would not be at all-time highs in wealth and income.

The experience of most people is that their job and income is secure during a recession. There are other reasons for this, which Barry Ritholtz will deal with in next week's Outside the Box.Bottom line, the American consumer is comfortable with taking on more risk than in the past. Thus, he sees real little reason to change his consumer spending habits, or increase his savings.

Whether from rising US rates or simply the end of a cycle, the US will eventually fall into recession. The engine of global growth will sputter, and this time it will be the consumer that is the problem. Whether that is in 2006 or 2007 or even later, it will happen. The business cycle has not been repealed.You can count on a major stock market decline in the next recession. The average decline is 43% in a recession. Can we say Dow 6,000? That means many boomers, who are only a few years from retirement, are going to be very disappointed, to say the least.

Because US mortgages are “no-recourse” loans (lenders have no recourse to the house’s owner beyond the value of the house), individuals with negative equity have an incentive to default. Martin Feldstein, FT May 7 2008

Pain of Foreclosures Spreads to the Affluent

This home on Hettiefred Road in Greenwich, Conn., came close to being auctioned off three times as a result of foreclosure actions. But each time, its owner managed to rescue his position.

ACROSS the United States, there were 243,353 foreclosure filings in April alone.
The trend is unmistakable, many millions of American families will be losing their homes before long.
ROBERT J. SHILLER, NYT May 18, 2008

nearly three times the total in the same month just two years ago, according to RealtyTrac, a company that follows the numbers. The trend is unmistakable, and suggests that, without government intervention, many millions of American families will be losing their homes before long.

What would this mean in human terms? Picture a line of moving trucks extending for hundreds of miles: they are taking the furniture of countless families to storage lockers. Picture schoolchildren saying goodbye to their classmates. They aren’t going on vacation: they are being abruptly moved to the other side of town.

Why Robert Shiller Is Worried About the Trump Rally
Still about 30 percent below its high in 2000, stocks are almost as expensive now as they were on the eve of the 1929 crash.Bloomberg 14 March 2017

In nominal terms, the Dow is up 70% from its peak in January 2000.The Dow is up only 19% in real (inflation-adjusted) terms since 2000.
A 19% increase in 17 years is underwhelming.
The national home price index that Case and I created is still 16% below its 2006 peak in real terms.
But hardly anyone focuses on these inflation-corrected numbers.
Robert J. Shiller, Project Syndicate 18 Jnuary 2017

What Robert Shiller, a Nobel economics laureate at Yale University, calls “narrative economics”
The key insight, he says, is to move on from the economic assumption that people think rationally
John Authers FT 12 March 2018

Narratives follow the same course epidemiologists have discovered in diseases — a steady beginning leads to a spike,
and then a swift decline, with the chance of later recurrence. The epidemic is more deadly if it ties in with an existing constellation of concern.

Robert Shiller presidential address to the American Economic Association.
It was something out of the usual — as we should expect from as fertile, contrarian and original thinker as Shiller
— namely a plea for economists to take seriously the importance of “narrative epidemics”.
That is to say, be aware of the stories people tell one another about the economy, because they may have real effects.
Martin Sandbbu, FT 12 January 2017

Shiller’s paper is a rich read. It proposes a causal role for stories: because people’s beliefs affect their actions,
the “viral spread” of some ideas and narratives over others can constitute a causal mechanism in the unfolding of an economic phenomenon or event.

Since the global financial crisis and recession of 2007-2009, criticism of the economics profession has intensified.
The failure of all but a few professional economists to forecast the episode – the aftereffects of which still linger – has led many to question whether the economics profession contributes anything significant to society.
If they were unable to foresee something so important to people’s wellbeing, what good are they?
Robert J. Shiller, Project Syndicate 15 January 2015

As far as I can find, almost no one in the profession – not even luminaries like John Maynard Keynes, Friedrich Hayek, or Irving Fisher – made public statements anticipating the Great Depression.

As the historian Douglas Irwin has documented, a major exception was the Swedish economist Gustav Cassel.
In a series of lectures at Columbia University in 1928, Cassel warned of “a prolonged and worldwide depression.”
But his rather technical discussion (which focused on monetary economics and the gold standard) forged no new consensus among economists,
and the news media reported no clear sense of alarm.

Ultimately, economic progress depends on creativity.
That is why fear of “secular stagnation” in today’s advanced economies has many wondering how creativity can be spurred.
One prominent argument lately has been that what is needed most is Keynesian economic stimulus – for example, deficit spending. After all, people are most creative when they are active, not when they are unemployed.
Robert J. Shiller, a 2013 Nobel laureate in economics, Professor of Economics at Yale University, Project Syndicate 18 november 2014

Others see no connection between stimulus and renewed economic dynamism.
As German Chancellor Angela Merkel recently put it, Europe needs “political courage and creativity rather than billions of euros.”

The Writing Is On The Wall
The "Shiller P/E" shows that U.S. equity valuations are pushing towards crash-worthy levels.
This measure of long term earnings power to current price is currently at 25.3x,or close to 2 standard deviations away from its long run median of 15.9x
Tyler Durden, zerohedge, 12 May 2014

First developed by Nobel Prize winner Robert Shiller for his book “Irrational Exuberance” in 2000,
it measures the current price of the S&P 500 as a multiple of 10 year average corporate earnings.
It is essentially what old-school analysts would call an earnings power ratio, since it incorporates good and bad years into one across-the-cycle measurement.

For you bell-curve fans out there, the standard deviation of the 1,600 monthly observations back to 1880 for the Shiller P/E is 6.6.
That puts 95% of the distribution between 3.3x and 29.7x.

Bear market won’t come until the yield curve says so: Kleintop
Says Jeffrey Kleintop, chief market strategist at LPL Financial:
the yield curve has a perfect track record of predicting the top of the stock market over the past 50 years, and it’s not signaling a bear market right now.
MarketWatch, May 13, 2014

The Global Economy’s Tale Risks
Fluctuations in the world’s economies are largely due to the stories we hear and tell about them.
These popular, emotionally relevant narratives sometimes inspire us to go out and spend,
at other times, they put fear in our hearts and impel us to sit tight, save our resources, curtail spending, and reduce risk.
They either stimulate our “animal spirits” or muffle them.
Robert Shiller, Project Syndicate March 2014

CAPE
Robert Shiller's cyclically-adjusted price-earnings ratio is, as recent research has shown,one of the best ways of predicting long-term returns in the stockmarket. But it is not popular because it shows the US market as expensive in historical terms.Buttonwood, The Economist, Febr 13th, 2014

Not only does today's CAPE of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years coupled with sluggish earnings growth suggests that this market is also seriously overbought
Today's CAPE is just slightly less expensive than the 27x level seen at the October 2007 market peak and modestly below the level seen before the stock market crash in 1929.
John Mauldin, 27 January 2014

CAPERobert Shiller has been out there talking about a stock-market bubble again. “The boom in the U.S. stock market makes me most worried. Also, because our economy is still weak and vulnerable.”
Shiller has some clout among investors because he called a bubble in the U.S. housing market
via his book “Irrational Exhuberance” just as everyone thought prices had nowhere to go but up.
MarketWatch, December 2, 2013

Last week, Shiller said he was concerned about a rise in his cyclically adjusted price-to-earnings ratio, CAPE

CAPE is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings.
If the ratio is above the long-term average of around 16x, the stock market is considered expensive.
Currently, the CAPE is at 24.42x, which has some people freaked out that the stock market is about to crash.
Indeed, when we were at these levels at 2008, we soon saw sharp drops in the stock market.

Is Economics a Science?
– I am one of the winners of this year’s Nobel Memorial Prize in Economic Sciences,
which makes me acutely aware of criticism of the prize by those who claim that economics
– unlike chemistry, physics, or medicine, for which Nobel Prizes are also awarded – is not a science. Are they right?
Robert J. Shiller, Project Syndicate, 6 November 2013

Critics of “economic sciences” sometimes refer to the development of a “pseudoscience” of economics, arguing that it uses the trappings of science, like dense mathematics, but only for show.
For example, in his 2004 book Fooled by Randomness, Nassim Nicholas Taleb said of economic sciences:
“You can disguise charlatanism under the weight of equations, and nobody can catch you since there is no such thing as a controlled experiment.”

Robert J. Shiller is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. He is the author of Irrational Exuberance, the second edition of which predicted the coming collapse of the real-estate bubble, and, most recently, Finance and the Good Society.

A new economicsThe failure of the dismal science to predict and explain the worst financial crash since the Depression has understandably prompted some reflection among the more thoughtful ranks of academics.
Financial Times editorial, November 12, 2013

Mathematics should, of course, not be neglected, but the emphasis on abstract theory should be downgraded in favour of a more balanced intellectual diet. This should include the relatively neglected discipline of economic history.

The failure to predict the crash not only unsettled Queen Elizabeth II – who famously gathered some economists together to ask them how they had missed it.

The Flat Earth Society has all but disappeared, but the efficient-market hypothesis is alive and well. This week, the Nobel Memorial Prize in Economic Sciences was awarded to its most tenacious advocate, Eugene F. Fama of the University of Chicago.
Robert Shiller of Yale University dubbed the efficient-market hypothesis “the most remarkable error in the history of economic theory.”By trying to have it both ways, the Nobel committee missed a chance to confirm that observed experience has undermined a beguiling but simplistic theory that has charmed the economics profession.
Roger Lowenstein, writing a book on the origins of the Federal Reserve System, Bloomberg 16 October 2013

Robert C. Merton, who won an economics Nobel in 1997 for his work in options theory, recognized how incompatible the two views are.
“If Shiller’s rejection of market efficiency is sustained,” he wrote in 1986, “then serious doubt is cast on the validity of this cornerstone of modern financial economic theory.”

Merton was rudely validated some years later, when he was a partner at Long-Term Capital Management LP, which, like many other hedge-fund managers, used an assumption of randomness in its risk-exposure models. Those calculations turned out to be way off. Markets moved in the wrong direction, in very nonrandom ways, and the fund collapsed in 1998.

If anyone ever doubted that the Nobel Prize for Economics was a farce, Monday’s announcement of the latest winners should put the matter to rest.
Fama questions whether “bubbles” exist. Shiller says they are common, and easy to see. Fama said U.S. house prices weren’t in a bubble in 2006, even in retrospect.
Shiller warned that they were—even before the crash. (He also correctly warned of a stock-market bubble in the late 1990s).
Fama thinks you should never try to time the market, because future returns are completely unpredictable and stocks will follow a “random walk.”
Shiller says that for most of the past century or more you could have timed the market quite easily.
All you really had to do was to invest in the stock market when stocks were cheap (when measured against the previous 10 years’ earnings).
MarketWatch, 15 October 2013

It is in some part Robert Shiller's fault that I am an economist.
Financial markets are supposed to tell the real economy the value of providing for the future--of taking resources today and using them nor just for consumption or current enjoyment but in building up technologies, factories, buildings, and companies that will produce value for the future.
And Shiller has, more than anyone else, argued economists into admitting that financial markets are not very good at this job.
Brad DeLong, October 14, 2013

Shiller was right about market irrationality then, and he’s still right now
— with two big bubbles that he called correctly under his belt.The question we should ask, however, is why the economics profession has been so resistant to the obvious.
Paul Krugman December 3, 2010

I remember 1988; 1988 was a friend of mine. By 1988, it was already obvious that equilibrium business cycle theory had failed. Shiller had already circulated his devastating demonstration that asset prices were much too volatile to be explained by fundamentals, and the 1987 market crash had provided an object lesson in panic. Also, by the way, the savings and loan mess was illustrating the problems with inadequate financial regulation.

Robert Shiller, the Yale economist who nailed the housing bubble before it burst"Housing traditionally is not viewed as a great investment.
It takes maintenance, it depreciates, it goes out of style. All of those are problems.
And there's technical progress in housing. So, new ones are better."
These were some of the issues Shiller addressed in his classic book, "Irrational Exuberance."Business Insider 7 February 2013

The lessons of 1979-82
Paul Krugman July 30, 2009

Here’s what happened: the Fed decided to squeeze inflation out of the system through a monetary contraction. If you believed in Lucas-type rational expectations, this should have caused a rise in unemployment only to the extent that people didn’t realize what the Fed was doing; once the policy shift was clear, inflation should have subsided and the economy should have returned to the natural rate. If you believed in real business cycle theory, the Fed’s policies should have had no real effect at all.

What actually happened was a terrible, three-year slump, which eased only when the Fed relented.

- In the United States, the return to demand management began as early as the summer of 1982, when a three-year recession and the bankruptcy of the Mexican government persuaded the Fed that its experiment with monetarism had gone too far.

I'm not an economist or a Wall Street strategist. Moreover, I'm not a senior financial industry executive or a central banker. So, based on the criteria the mainstream media uses to qualify its "experts," I guess my opinion doesn't matter very much.

However, there is one fellow who is widely viewed as an expert and who has proven that he actually understands economic reality. His name is Professor Robert Shiller
Financial Armageddon 11/4 2010

Check out the chart below, from Professor Shiller's web site. The blue line is the cyclically adjusted PE ratio for the last 130 years.

America, from its inception, was a speculation,” begins the historian Aaron M. Sakolski’s 1932 classic, The Great American Land Bubble. George Washington himself was a land speculator, Sakolski notes, and by Washington’s time it was widely perceived that America would eventually be populated much more densely by vast numbers of immigrants, leading many investors to dream of rapidly rising land prices. Waves of speculative mania swept towns, cities, and regions from the 18th century onward, even along the vast and empty frontier. Up, up went the prices. And then, inevitably, down.

Sakolski was seeking to make sense of the biggest national housing bust in American history—at least so far. It began in 1926 and spread to the stock market in 1929, triggering a severe banking crisis that in turn affected almost all types of businesses. Home prices fell a total of 30 percent from 1925 to 1933, and the unemployment rate reached 25 percent at the depth of the Great Depression.

Bubbles are a lot like epidemics. Every disease has a transmission rate (the rate at which it spreads from person to person) and a removal rate (the rate at which those individuals recover from or succumb to the illness and so are no longer contagious). If the transmission rate exceeds the removal rate by a certain amount, an epidemic begins.

Irrational Exuberance
Irrational Exuberance is a March 2000 book written by Yale University professor Robert Shiller, named after Alan Greenspan's "irrational exuberance" quote. Published at the height of the dot-com boom, it put forth several arguments demonstrating how the stock markets were overvalued at the time.Wikipedia

Congress appears eager to help more than a million homeowners facing foreclosure
Robert Shiller, a Yale economist who has long argued there was a bubble in home prices, thinks the plan will do little to stop the slide in housing prices.
CNN 22/4 2008

The runup earlier this decade, fed by low interest rates from the Federal Reserve and lax underwriting standards by lenders, created a bubble that hasn't yet completely deflated.
Shiller notes that prices shot up 85% when adjusted for inflation from 1997 through mid-2006 and have fallen only about 15% since then.

Two recent interviews, one with Yale University economist Robert Shiller and the other with National Association of Realtors Chief Economist David Lereah, paint a wildly divergent picture regarding the state of the nation's housing market.Tim Iacono 5/3 2007

Equities look overvalued, but where is the turning point?
The cyclically adjusted measure follows the method of Professor Robert Shiller of Yale university: it is the ratio of stock prices to the moving average of the previous 10 years’ earnings, deflated by the consumer price index.Martin Wolf, Financial Times, March 7, 2007

If a prophet is only as good as his last prophecy, then you'd be wise to listen to Robert Shiller.
The stock market crash that followed was no surprise to Shiller and proved that he had called it right.Now he's warning that a similar collapse may soon apply to the real estate market.
ABC News 24/3 2006

Shiller said that the same psychology that applies to stock market investors now drives the real estate boom. He called it irrational exuberance, coincidentally the title of his 2000 book about the stock market.
Shiller argued that human emotion, not strategic economic factors, drives prices and property buying.

Just because prices are more reasonable than they were doesn't mean they're reasonable.
The preeminent teacher of that lesson is Robert Shiller, a Yale professor with a strong record of thinking independently and being right. His book Irrational Exuberance updated
Fortune 26/12 2005

"The trailing P/E ratio for the S&P composite is still around 25, vs. a long-term average of 15."

The commonly cited figures—a current market multiple of 17, vs. a historical average of 15.2—are based on the previous 12 months' earnings. But, as Shiller points out, that's foolish: "Twelve months is kind of short, only a fraction of one business cycle."

Mr Greenspan was not
certain that the equity market was indeed a bubble. But by September, he was
explicitly referring to it in such terms: "I recognise that there is a stock
market bubble problem at this point," he said at the September 24, 1996 meeting
- the day the Dow closed at 5874.03.

Three years ago, at the height of the stock bubble,
Paul Volcker, Mr
Greenspan's predecessor as Fed chairman, issued a famous warning: that the
world economy was dependent on the US economy, which was dependent on the stock
market, which was dependent on fifty stocks, half of which had never reported
any earnings. (FT.com site; Jul 19, 2002)

A stock market bubble exists when the value of stocks
has more impact on the economy than the economy has on the value of stocksJohn Makin
November, 2000

The root cause of this recession
was the bursting of one of the biggest financial bubbles in history.It is
wishful thinking to believe that such a binge can be followed by one of the
mildest recessions in historyand a resumption of rapid growth.The
Economist January 2002

If market follows the same script as in 1929, trouble lies directly ahead
MarketWatch, Feb. 11, 2014 with nice chart

There are eerie parallels between the stock market’s recent behavior and how it behaved right before the 1929 crash.
That at least is the conclusion reached by a frightening chart that has been making the rounds on Wall Street.
The chart superimposes the market’s recent performance on top of a plot of its gyrations in 1928 and 1929.

Lessons from the Fed’s Mistake of 1932
This week sees the 80th birthday of a fateful Fed decision in 1932, a decision which some scholars believe led inexorably to the bank failures of early 1933, and the suspension of US membership of the Gold Standard.
That decision was to end the only period of aggressive quantitative easing which was attempted by the Fed during the worst period of the Great Depression between 1929 and 1933.
Gavyn Davies, Financial Times 29 July 2012

That is a point which the ECB, in particular, should reflect upon this week.

"Whatever happens, we don't want to repeat the 30s."
The last time the world had seen a banking crisis on this scale, the result had indeed been the Great Depression. We forget that in the UK, the Depression was not nearly as Great
Stephanie Flanders, BBC, 23 December 2010

Most people think of the Great Depression as originating in the stock market crash of 1929. But Nobel Prize-winning economist Vernon Smith's research indicates that the 1929 crash was itself
the result of an earlier collapse in the boom housing market during the Roaring '20s.
The Bellingham Herald, 5/6 2009

Smith, professor of economics and law at Chapman University, won his Nobel in 2002.
He spoke Friday, June 5, before a standing-room-only crowd in Fraser Hall at Western Washington University.

"We still have shoes to drop out there."

Examples: Large numbers of adjustable-rate mortgages will reset at higher rates in the next couple of years, putting more households at risk of foreclosure and piling more losses on mortgage lenders. And sharp drops in consumer spending have yet to play themselves out in the commercial real estate markets. Increasing numbers of commercial loans to retailers are likely to go sour in the months ahead.
"That has yet to hit the banking sector," Smith said.

The housing boom and bust that touched off the economic chain reaction was at least partly due to federal policies that made it easier for people to borrow money to buy homes. Politicians from both parties pushed those policies because they were popular, Smith said.

We should not try to avoid 1929. We have already failed.
The best we can do now is to avoid 1930, 1931 and 1932
What about the €200bn European Union stimulus package that was agreed in a watered-down form by EU leaders on Friday? Unfortunately, it is a public relations exercise first and foremost, designed to dupe people into believing that the EU is finally doing something. Wolfgang Münchau, Financial Times, December 14 2008

The Road To Revulsion
"There is nothing in the situation to be disturbed about." -Secretary of the Treasury Andrew Mellon, Feb 1930
cit. by James Montier June 16 2008

We have long been proponents of the Kindleberger/Minsky framework for analysing bubbles (see Chapters 38 and 39 of Behavioural Investing for all the details). Essentially this model breaks a bubble's rise and fall into five phases as shown below.

Displacement - The birth of a boom
Credit creation - The nurturing of a bubble
Euphoria - Everyone starts to buy into the new era.
etc etc

I see nothing in the present situation that is either menacing or warrants pessimism. . . . I have every confidence that there will be a revival of activity in the spring and that during the coming year this country could make steady progress.
Andrew W. Mellon, U.S. Secretary of the Treasury, December 31, 1929John Makin, False Dawn, May 30, 2008

The bursting of every bubble is followed by statements suggesting that the worst is over and that the real economy will be unharmed. The weeks since mid-March have been such a period in the United States. The underlying problem--a bust in the residential real-estate market--has, however, grown worse, with peak-to-trough estimates of the drop in home prices having gone from 20 to 30 percent in the span of just two months. Meanwhile, the attendant damage to the housing sector and to the balance sheets tied to it has grown worse and spread beyond the subprime subsector.
Of the 130 million U.S. housing units, 18.5 million--almost 15 percent--are empty. This bodes ill for the outlook for homebuilding; house prices; and the balance sheets of commercial banks, investment banks, and American households. In June, Congress will pass the Foreclosure Prevention Act of 2008. This is a symbolic measure that will not become effective until October 1 and, given its cumbersome structure, will provide virtually no relief to the households facing foreclosure that it is designed to help.

As travellers, we all love the euro. It made my life marginally easier.
But let's be serious. A minor convenience is nothing set against the fate of nations.It was the perverse workings of the fixed exchange Gold Standard that turned the US slump into a global depression in 1931.(See 'Fetters of Gold' by Berkeley’s Barry Eichengreen. A brilliant book.)

Det var inte inflationen - det var Depressionen
Germany "the new democracy survived serious threats to its existence in the early postwar years and found a semblance of stability from 1924 to 1928,
only to be submerged by the collapse of the economy after the Wall Street crash of 1929."Ian Kershaw, New York Times, February 3, 2008

This huge monetary expansion perpetrated by the Federal Reserve has contributed to the biggest speculation in every conceivable asset category and has been accompanied by unprecedented hubris, greed and outright fraud.
This will be punished. The punishment is likely to fit the crime. Ian Gordon, Economic Forecaster and Interpreter of Kondratieff Cycle

In the end, the Fed can always stop a deflationary spiral.As Bernanke said to Milton Freidman on his 90th birthday, the Fed will not repeat the monetary crunch it allowed to happen 1930-32.
"Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."Ambrose Evans-Pritchard on 14 Dec 2007

You are Chairman Bernanke. What do you do?
A conscientious fellow, you try first to do no harm. You have made a lifelong study of deflation and the Great Depression. Of all the mistakes you could make at the helm of the Federal Open Market Committee, there is one you really want to avoid: You do not want to go down in history as the scholar of the Great Depression who inadvertently steered the highly leveraged U.S. economy into Great Depression Part II.
You will be slow to tighten monetary policy when home prices are deflating, let the cpi be what it may. James Grant, 9/6 2006

Ben S. BernankeEssays on the Great Depression
Princeton University PressMay 10, 2000

Ben Bernanke has gathered together his essays on why the Great Depression was so devastating. This broad view shows us that while the Great Depression was an unparalleled disaster, some economies pulled up faster than others, and some made an opportunity out of it. By comparing and contrasting the economic strategies and statistics of the world's nations as they struggled to survive economically, the fundamental lessons of macroeconomics stand out in bold relief against a background of immense human suffering. The essays in this volume present a uniquely coherent view of the economic causes and worldwide propagation of the depression.

He had presided over the greatest prosperity in U.S. history when Calvin Coolidge announced from the Black Hills of South Dakota, “I do not choose to run for president in 1928.” In March 1929, Coolidge turned the presidency over to Herbert Hoover, the commerce secretary he derided as “The Wonder Boy.” Six months later came the Wall Street crash and Great Depression with which Hoover’s name is forever associated.
Coolidge was enjoying retirement.Is Alan Greenspan the Calvin Coolidge of our time?Patrick J. Buchanan, february 2006

Greenspan's most vehement critics are convinced he has made a fundamental error as a monetary economist.The hairshirt economists vs. the cheerleaders for growth-is-goodBusiness Week 28/6 2005

One of the fascinating things about the extended media commentary on the 75th anniversary of the Wall Street Crash is that no one has a definitive answer as to the cause.
The interpretation that I find most interesting is the notion that bubbles and crashes tend to accompany the rise and fall of financial hegemonies.
John Plender, FT 31/10 2004

Wall Street Crash: 75 years onMarkets may rise and markets may fall, but there was only ever one Wall Street Crash. BBC 27/10 2004

In October 1929, Professor Irving Fisher of Yale University, a great guru of the markets, earned immortality with the pronouncement: "stock prices have reached what looks like a permanently high plateau." BBC 27/10 2004

Over a six day period, the high-tech NASDAQ stock index in the U.S. lost 17% of its value, dropping by November 13 2000 to below 2,900, its lowest value since November 3 1999.
In paper terms, it represented an evaporation of more than $1.7 trillion in share values since the all-time high of 5,123 in March 2000, or a drop of 44.3% in 8 months.Market Plunges and Fed steps in again

Over two days this week, Gerrit Zalm, the Netherlands finance minister, and Nicolas Sarkozy, his French colleague, have set up a live experiment that will assure full employment for future graduate students of comparative economics.
Financial Times editorial 23/9 2004

The intriguing question facing eurozone policy makers is whether the two ministers, with their very different budgetary prescriptions for 2005, can boost employment more broadly in their economies while bringing their deficits below the limit of 3 per cent of gross domestic product set by the EU's stability and growth pact.

The policies could not be more different. Mr Zalm, with determined rigour, has brushed aside street protests to present a hair-shirt, supply-side budget which combines belt-tightening for consumers and corporate tax breaks for business. He hopes the deficit will fall to 2.6 per cent next year from 3 per cent in 2004 and structural reforms will attract investment, creating growth and jobs in the medium term.

Mr Sarkozy's budget, by contrast, appears largely pain-free. Buoyed by a recovery in government revenues, the French finance minister forecast that the public finances next year would show a deficit of 2.9 per cent

- meeting EU rules for the first time since 2001.
An International Monetary Fund study, released last night, suggested that fiscal policy in the eurozone has weakened since the introduction of the single currency in 1999.

Against this background, it is difficult not to sympathise with Jean-Claude Trichet, the European Central Bank president, who warned again yesterday of the need for further budget consolidation and the dangers of loosening the stability pact's sanctions against excessive deficits.

What is the relationship between Weimar Germany and Wall St. of the late 90s? On the surface, what could be more different? Stock market booms are the best of times while hyperinflation is a nightmare.Robert Blumen, Ludwig von Mises Institute

Stand by for a pensions bail-outA re-run of the S & L disaster
John Plender Financial Times 13/9 2004

In the light of United Airlines' proposal to stop contributing to its pension funds, comparisons are increasingly being made between today's overstretched US pension fund system and the savings and loans crisis of the 1980s. Not without justice, although the problem in pensions will be more of a slow-burn affair since pension funds, unlike S & Ls, are unleveraged.

The nub of it is that private defined benefit schemes in the US have a $400bn funding gap. Meantime, the Pensions Benefit Guarantee Corporation (PBGC), the agency that insures private pensions for 44m workers and retirees, had an $11.2bn deficit at the end of 2003. It also has $85bn in exposure to companies with junk bond ratings, which implies a high risk of default.

The position can only worsen given the degree of moral hazard built into the system, whereby the premiums paid to the PBGC do not adequately reflect the risks. One measure of this, highlighted by Bradley Belt, executive director of the PBGC, is the fantastic bargain United Airlines has enjoyed at the insurer's expense. It has paid little more than $50m in premiums since the agency's inception in 1974. Yet if its pension plans terminate, the PBGC would be hit by a claim of $6.4bn.

The agency is thus in a position not unlike that of the International Monetary Fund. Its mere existence encourages morally hazardous behaviour and everyone expects it to act as a financier of last resort for the whole system. Yet it lacks the resources to do more than a marginal firefighting job in the event of a systemic crisis. And the potential for systemic crisis increases all the time because the weaker players in the system are encouraged, as in the S & L fiasco, to speculate their way out of trouble.

The risks ahead for the world economyFred Bergsten The Economist print edition Sep 9th 2004
Fred Bergsten is director of the Institute for International Economics in Washington.
His book, “The United States and the World Economy: Foreign Economic Policy for the Next Administration” is forthcoming.Very Important Article

Bubbles are getting blown out of all proportion
The financial press is full of grim prognostications of economic damnation postponed but not avoided.
The monetary moralists preaching inevitable doom for the US economy because the Fed dared to stabilise the economy after the bubble's collapse are simply wrong
Adam Posen Financial Times 8/9 2004The writer is a senior fellow at the Institute for International Economics
Chart sources: Author’s calculations from Adam Posen ‘It Takes More Than A Bubble to Become Japan’ (Reserve Bank of Australia 2003)

Like the hellfire preachers of yesterday, today's economic pundits are taking a stern line on excess. Economies that enjoyed asset price booms, notably the US, are damned to pay for their wanton ways. Central banks that attempted to offset the negative effects of a bubble's burst, notably the US Federal Reserve, are merely postponing the day of judgment and, if anything, compounding their sin by blowing up other bubbles - in housing, or in government bonds, or both. The financial press is full of grim prognostications of economic damnation postponed but not avoided.

This is all pernicious (pernicious \pur-NISH-us\, adjective:
Highly injurious; deadly; destructive; exceedingly harmful/nonsense). Pernicious because it discourages central banks from responsibly doing their job of stabilising the real economy, as the Fed correctly did in 2001-03.
Nonsense because there is no evidence to support these claims. Bubbles have only rarely caused the lasting damage that these commentators assert as unavoidable destiny; when they have, it has been because central banks have failed to respond to the bubbles' aftermath.

The outdated but apparently still widely attractive monetarist image of liquidity as toothpaste - if you squeeze the
tube in one place, it bulges somewhere else - does not stand up empirically.

This cross-national evidence is consistent with economic historians' assessments of the US experience. Among the many booms, panics and busts in the 19th and 20th centuries, only those accompanied by banking problems had negative consequences lasting beyond a few quarters. Bubbles can pop with limited macroeconomic impact, and usually do.

As for the second contention, the moral hazard story of “the Greenspan put” - in which investors believe the Fed will step in to protect them if the market crashes, and so act recklessly - is a cute story, but that is all it is. Investors do not decide whether or not to risk their money based on whether the central bank cut rates in the aftermath of the last bubble.

In fact the evidence is that, if anything, investors have less risk tolerance for extended periods after bubbles, whether or not the central bank cuts rates. Only two of the 15 big industrial economies (Finland and Italy) have had recurring bubbles since 1970 - all the rest had to wait through a long period of fading memories and turnover in financial services personnel before a second asset price boom emerged (if one ever did).

Deflation did not emerge in Japan until the end of 1997, many years after the bubble had burst. It was a consequence of years of failure by the Bank of Japan to respond adequately to slowing growth, the Ministry of Finance's decision to raise taxes in a recession and the corporate sector's inability to face up to bad loans, a problem that was allowed to grow to vast proportions. After the bubble burst, the BoJ's unwillingness to stimulate the economy unless government and business “got the rot out” served only to encourage more wasteful government spending, greater declines in corporate and bank capital and constant renewal of bad loans.

Thankfully, the Fed, as its aggressive rate cuts in 2001-03 show, has learnt these lessons. The monetary moralists preaching inevitable doom for the US economy because the Fed dared to stabilise the economy after the bubble's collapse are simply wrong.

All reasonable people agree that today, with rising inflation, burgeoning Federal deficits and the possibility of a stagflationary oil shock, interest rates should be on an upward path in the US. But the Fed is right to wait for the data to come in to determine the pace of that increase.

America on the comfortable path
to ruinThese two facts - the rest of the world's surplus output and
the US goal of full employment - explain the global macro-economic picture
Martin Wolf, Financial Times, August 18 2004

From 1996 to 2003 US real demand has grown faster than real
gross domestic product in every year (see chart). When demand has grown slowly,
as in 2001, output has grown even more slowly. Thus, the US authorities had to
generate faster growth of demand than of potential output, with the difference
spilling over on to the rest of the world via growing current account deficits.

Was the fiscal slide inevitable? No, but it could have been
avoided only if the US had been prepared to accept a slump. Yet no US
administration would have tolerated this outcome.

For the same reason, the desire of both presidential
candidates to reduce the fiscal deficit in coming years is meaningless without
change in the external position. The point is powerfully made in the latest in
a series of papers authored by Wynne Godley and associates for the Levy
Economics Institute and the Cambridge Endowment for Research in Finance.
click here

Let us be blunt about it. The US is now on the comfortable
path to ruin. It is being driven along a road of ever rising deficits and debt,
both external and fiscal, that risk destroying the country's credit and the
global role of its currency. It is also, not coincidentally, likely to generate
an unmanageable increase in US protectionism.

Worse, the longer the process continues, the bigger the
ultimate shock to the dollar and levels of domestic real spending will have to
be. Unless trends change, 10 years from now the US will have fiscal debt and
external liabilities that are both over 100 per cent of GDP. It will have lost
control over its economic fate.

What cannot last will not do so, as the late Herb Stein
famously remarked.

The essence of the needed changes is quite clear: a further
substantial devaluation of the dollar, together with a sizeable rise in
domestic demand, relative to potential output, in almost all other important
economies of the world.

See also FT leader: Dollar stands
on a precipice Financial Times; Jan 02, 2003 As the late Herbert Stein,
former chairman of the US council of economic advisers, once said: "If
something cannot go on forever, it will stop."

The combination of an ever-rising US current account
deficit with a strong dollar must cease. Indeed, it already is doing so. The
currency weakened in 2002. It is rather likely to weaken further in 2003. The
present course of the US economy is unsustainable.

Net US liabilities to the rest of the world are some 25 per
cent of gross domestic product - in the neighbourhood of $2,500bn
(£1,562bn). In the first three quarters of 2002, the current account
deficit ran at close to five per cent of GDP. As recently as 1997, however, the
deficit was only 1.5 per cent of GDP. It is bigger this year than two years
ago, despite last year's economic slowdown. Since the beginning of 1997, trend
growth of exports of goods and services, at constant prices, has been 2.2 per
cent a year, of GDP 3 per cent and of imports 7.4 per cent. Even under quite
conservative assumptions, the current account deficit could, on current trends,
be over 7 per cent of GDP by 2007. By that year, US net external liabilities
would, at current exchange rates, be close to 65 per cent of GDP. If the dollar
is to remain strong, despite these deficits, the rest of the world must
accumulate net claims on the US economy at $500bn a year, and rising, for the
indefinite future. This is hard to imagine.

Already, there has been a steep decline in net private
foreign purchases of US assets, from $978bn in 2000 to an annual rate of just
$560bn in the first three quarters of 2002. Net foreign direct investment has
collapsed, from $308bn in 2000 to an annualised $14bn in 2002. This decline in
private foreign purchases of US assets has been offset by a big increase in
foreign government net purchases of US

Asset prices shares
assets, from $38bn in 2000 to an
annualised rate of $136bn in 2002. There has also been a steep fall in US
private purchases of foreign assets, from $605bn in 2000 to an annual rate of
just $380bn in 2002. If foreign governments stopped propping up the dollar and
US investors invested abroad, as before, the dollar would tumble. Other
currencies must rise if the dollar is to fall. But the two biggest economies
after the US - the eurozone and Japan - are highly dependent on export demand,
at least for the moment, while no big economy offers obviously superior returns
to those available in the US. Moreover, other governments, particularly in
Asia, are desperately unwilling to see their currencies rise against the
dollar. The most potent of all large-scale purchaser of dollars is Japan. Its
vast foreign reserves, already $395bn at the end of 2001, rose to $461bn by
October 2002. With the finance minister talking of a yen exchange rate below
Y150 to the dollar and pressure on the Bank of Japan to expand the money
supply, further purchases are probable. If the dollar is to fall, the important
currency against which this is likely to happen is the euro, since it belongs
to the one large entity whose authorities will refuse to buy dollar assets in
large quantities. The dollar has already fallen 16 per cent against the euro
since the end of January 2002. This slide could easily continue in 2003. This
is a tale of irresistible force meeting immovable objects. The force is the
growing pile of US liabilities. The objects are the low real returns in other
big economies and the unwillingness of many governments to tolerate currency
appreciation. In the short term, the objects may win. In the long run, the
force will be stronger. The dollar must fall. The longer it remains high, the
bigger its fall will be.

Greenspan is running out of buttons to pushPeter Hartcher, Financial Times, August 10
2004The writer is international editor at The Sydney Morning Herald and
a visiting fellow at the Lowy Institute for International Policy. He is author
of a forthcoming book on Alan Greenspan and Wall Street, entitled Bubble
Man

The US economy has grown reasonably fast since the
second half of 2003 and the general expectation seems to be that satisfactory
growth will continue more or less indefinitely. The expansion may,
indeed, continue through 2004 and for some time beyond. But... it will
certainly not happen without a cut in domestic absorption of goods and services
by the US which would impart a deflationary impulse to the rest of the
world Wynne Godley et al, The Levy Economics Institute, July 2004

The US economy has grown reasonably fast
since the second half of 2003 and the general expectation seems to be that
satisfactory growth will continue more or less indefinitely.

But with the government and external deficits both so large and the
private sector so heavily indebted, satisfactory growth in the medium term
cannot be achieved without a large, sustained and discontinuous increase in net
export demand. It is doubtful whether this will happen spontaneously and it
certainly will not happen without a cut in domestic absorption of goods and
services by the US which would impart a deflationary impulse to the rest of the
world.

The US current account deficit has risen from about 1.5 per cent of
gross domestic product to over 5 per cent today. During the recent US slowdown,
the current account deficit has, remarkably, continued to rise. This is the
opposite of what one would normally expect and of experience in the early
1990s.

A net creditor for most of the 20th century, the US has seen its net
liability position move from a rough balance in 1988 to minus 24 per cent last
year. Yet, despite a current account deficit of 4.9 per cent of GDP in
2003, net liabilities to the rest of the world fell as a share of GDP. The
tumbling dollar reduced net liabilities by more than the current account
deficit increased them.

On average, according to the International Monetary Fund's latest World
Economic Outlook, real domestic demand will have grown at 3.8 per cent a year
in the US between 1996 and 2005, while real output will have grown at 3.5 per
cent.

The UK has an even bigger discrepancy, at half a percentage point a
year. Meanwhile, the eurozone's demand will have grown at a pitiable rate of
1.8 per cent, with output growth of only 2 per cent, and Japan's demand will
have grown at a still lower 1.2 per cent, with output growth at 1.5 per
cent.

In 2004, according to the Organisation for Economic Co-operation and
Development, the Anglosphere (the US, UK and Australia, but not Canada in this
case) will run a combined current account deficit of $636bn, with the US
deficit alone accounting for $555bn.

The Asset EconomyThe
income-driven impetus of yesteryear has increasingly given way to asset-driven
wealth effects. For consumers, businesses, policymakers, and investors, the
asset economy turns many of the old macro rules inside outStephen Roach
Morgan Stanley 21/6 2004

The equity bubble of the late 1990s was a transforming
event in many ways for the US economy. But there is one lasting implication
that stands out above all - an important transition in the character of the
American growth dynamic.

The income-driven impetus of yesteryear has increasingly
given way to asset-driven wealth effects. For consumers, businesses,
policymakers, and investors, the asset eco
nomy turns many of the old macro
rules inside out. In the end, it could well pose the most profound challenge of
all to sustainable recovery in the United States.

Kenneth Rogoff, formerly chief economist of the
International Monetary Fund, in the May issue of the Central Banker puts his
finger on a weakness of official assurances by saying "people tend to resist
thinking about low probability extreme events".

There are also dangers that are highly likely, but the
timing of which is uncertain.

Mr Rogoff cites the US current account deficit of 5 per
cent of gross domestic product, which he, like many others, regards as
unsustainable. Suppose, however, this suddenly reverts to balance. For
instance, a steep collapse in US house prices could lead to a sharp rise in
private savings. Indeed, he believes there is a high risk of a housing slump in
the US even though the boom there has not gone as far there as it has in the UK
or Australia.

A future correction would need to be accompanied, according
to the former IMF economic director, by a drop in the the dollar of over 40 per
cent in the short run and in the long run of about 12-14 per cent.

Short-term real interest rates in the Group of Seven
countries are still negative. In the US, they are minus 1 per cent. In core
euro countries, they are around zero. This compares with a normal historical
level of, say, 2 or 3 per cent.

There is also a gap of over 2½ percentage points
between prevailing international nominal short-term rates and the rates on
10-year government bonds (an upwardly sloping yield curve). Monetary policy is,
in the awful US financial jargon, "behind the curve".

I continue to believe that our stock market is the financial equivalent of an 8.0-plus earthquake waiting to happen.
Financial insanity is rampant. Folks are speculating in houses, with many having more than one real estate investment due to the financing that’s available and the belief that real estate is now bulletproof.
Bill Fleckenstein, CNBC 10/1 2005

The fact that Google could have a $50 billion valuation is one sign of the times.

I don’t believe that there has been a moment in time in the last 50 years where the stock market has been more lopsidedly tilted toward all risk and no reward.

Americas vaunted economic flexibility is
a mirage: it is fundamentally a product of financial engineering and endless
debt creation, which has persistently created the image of a dynamic economy,
successfully withstanding one shock after another, from the fall out of the
Asian financial crisis of the late 1990s or the devastating terrorist attacks
of September 11, 2001.

Beware bursting of the money bubble David Hale Financial Times May 30 2004 19:30

The financial markets have been hit by shocks from the Middle East over
the past few weeks. But the real risk to world markets is that the speculative
bubbles and "carry trades" that have developed as a consequence of American
monetary policy over the past year will unravel as the US Federal Reserve moves
to increase interest rates.

During the Nasdaq bubble of 1998-2000, US interest rates ranged between
4 per cent and 6 per cent. Since June 2003, they have stood at 1 per cent. The
advent of such low money market yields has unleashed speculative capital flows
to asset classes that played no role in the technology bubble of four years
ago.

Remember inflation? Remember fretting about accelerating consumer prices
and higher interest rates? Those days may soon be back.

John Makin, resident scholar at the American
Enterprise Institute in Washington:The blissful combination of higher
growth and lower inflation that has characterized the U.S. economy since last
spring is the inverse of stagflation, the nightmare scenario that followed the
oil shock of 1973-74 Still lower inflation is a distinct possibility. John Makin AEI 29/1
2004- We are nearing the end of a benign, unusual period of faster
growth and lower inflation and moving into a period of slower growth and higher
inflationIHT 15/4
2004

On Wednesday, the government reported that U.S. consumer prices shot up
more sharply than expected in March, rising 0.5 percent from a month earlier.
Excluding food and energy prices, the rise was still 0.4 percent, the biggest
monthly increase in two years. These early signs of a return to creeping price
increases  just a few months after the U.S. Federal Reserve pronounced
the risks of inflation and of deflation almost equal
 may put the central bank in a tight spot as pressure grows to raise
interest rates sooner than it might like.

We are nearing the end of a benign, unusual period of faster
growth and lower inflation and moving into a period of slower growth and higher
inflation, said John Makin, resident scholar at the American
Enterprise Institute in Washington. The resulting whiff of stagflation may
force the Fed to raise U.S. interest rates while growth is
slowing.

Those with a memory of what happens when a bubble
bursts know that, if history is any guide, the bear market that began in 2000
is not over - not by a long shot. By
Maggie Mahar Financial Times April 11 2004 19:36 The writer is the
author of Bull! A History of the Boom, 1982-1999 (HarperBusiness) What drove
the Breakneck Market - and What Every Investor Needs to Know About Financial
Cyclesamazon.com

How can one conclude that they are wrong? Because the US market has not
yet "reverted to a mean". Past experience suggests that when a bubble
collapses, a market cannot lay down a firm foundation for the next boom until
the pendulum has swung back to its mean, or average price.

Historically, at its mean, the S&P 500 has traded at 17 to 18 times
the previous year's earnings, and roughly 14 times estimates for the current
year, while yielding dividends of about 4 per cent. When a bear market scrapes
bottom, the pendulum inevitably swings too far in the other direction:
price-earnings ratios usually sink below 10, while the yield rises to at least
5 per cent.

Today, the S&P 500 fetches approximately 29 times last year's
earnings and roughly 18 times estimated earnings for 2004, assuming you believe
analysts' estimates. As for dividends, the average stock on the S&P yields
less than 2 per cent.

Meanwhile, the underlying economy deteriorates in what could be the
prelude to a second fall in equity prices. Debt builds, the dollar declines,
capital investment remains sluggish and, despite increased productivity, real
wages barely budge. Sceptics argue that a recovery built on debt and consumer
spending is no recovery at all.

So the crash of 1929 was followed by a 50 per cent rally. But then came
the crash of 1930-1932. When it was all over, the market had fallen some 86 per
cent from its pre-crash peak.

Similarly, the go-go market of the 1960s first sold off in 1970 when the
Dow plummeted from a high of nearly 1,000 to a low of 631. Investors assumed
that this was a nadir and, sure enough, late in 1970, the benchmark index began
to climb. The bear market rally of the early 1970s ran for a little more than
two years, reaching a climax early in 1973, with the Dow making a new high of
1,071. Many thought that a new bull market had begun. Within weeks, the the
crash of 1973-1974 began. When it bottomed, the Dow had sunk to 577 - seven
points below where it had traded in 1958.

An entire generation was driven out of the stock market. It would be
another eight years before a new bull market began.

The jobs picture is even worse than it
seems And despite what the experts say, inflation is out there, and
were feeling it already.Bill Fleckenstein, CNBC 15/3 2004

Using the seasonally adjusted total unemployment rate of 5.6% and adding
to it "discouraged" workers, the rate grows to 5.9%. Factor in other groups of
people who are underutilized in the work force, you can ratchet the number all
the way up to 9.6%. And, for the sake of comprehensiveness, if you use the
non-seasonally adjusted numbers, that rate would swell to 10.9%. So, those are
the numbers, and I'll leave readers to draw their own conclusions.

What's particularly scary is how pathetic job growth has been, despite
all the interest-rate cuts (nominal rates are near zero, and real rates are
essentially below zero), the two Bush tax cuts and now the refunds from the
last cut. Despite it all, we still can't get enough jobs created.

The failure of the US economic recovery, now
more than two years old, to produce meaningful job growth has generated much
talk about its political consequences. It could undermine President
George W. Bush's re-election prospects, and it certainly seems to be
contributing to the national alarm about outsourcing, trade and overseas
investment. But the bigger concern is that it may be starting to threaten
the strength and even the sustainability of the recovery itself. Financial
Times editorial 9/3 2004

With last Friday's dismal news from

the Labour Department that just
21,000 net new jobs were added in February, total non-farm payrolls remain
almost 2.5m below their pre-recession peak. For comparison, in the early 1990s
at the same stage of the cycle, in what was also called a jobless recovery,
non-farm payrolls had already surpassed their previous peak.

This weakness is, of course, the reflection of the economy's stellar
productivity performance; while US employment has remained at a standstill for
the past year, gross domestic product is up by more than 5 per cent.

If employment does not begin to show strength soon, consumers are likely
to retrench, weakening aggregate demand. To avoid that, either productivity
growth must, improbably, collapse, or output must accelerate.

A more plausible gentle slowdown in output per hour would need to be
accompanied by stronger demand and output elsewhere.

The American consumer has been surprisingly steadfast for the past three
years. Figures last week from the Federal Reserve showed why: household net
worth reached an all-time high at the end of last year as modest equity
increases were augmented again by gains in housing wealth. But even if the Fed
stays on hold for the rest of this year - as looks increasingly likely and
sensible - it has scant room to provide the stimulus that lowered mortgage
rates and helped raise house prices in the past three years.

The US has had a jobless expansion for more than two years. It will soon
start to test the limits of its durability.

Berkshire Hathaway, the insurance and
holding company run by legendary investor Warren Buffett, amassed a
record cash pile of $36bn in 2003 as the world's second-richest man once
again shied away from rising stock marketsFinancial Times 8/3 2004

"Our capital is underutilised now...It's a painful
condition to be in - but not as painful as doing something stupid," added Mr
Buffett. The chairman's caution has been largely justified in the past,
particularly during the technology bubble in 1999, which was the last time that
Berkshire shares underperformed against the S&P 500 and the year after its
previous cash peak.

Mr Buffett also highlighted a number of risks to the US
economy that add to last year's warnings on derivatives, mutual funds and
corporate governance.

In particular, he singled out the weak dollar as a cause
for concern and revealed that Berkshire Hathaway had $12bn invested in foreign
currencies to balance its exposure to the falling greenback. "Prevailing
exchange rates will not lead to a material letup in our trade deficit. So
whether foreign investors like it or not they will continue to be flooded with
dollars," said Mr Buffett. "The consequences of this are anybody's guess. They
could, however, be troublesome - and reach, in fact, well beyond currency
markets."

Last week, Alan Greenspan was
a study in contradiction. On Monday, he extolled the virtues of the
levered-up homeowner to a credit union conference. The next day, in a speech to
the Senate Banking Committee, he was singing a different tune altogether.
Fannie Mae and Freddie Mac, the giant providers of mortgage capital, he warned,
"are expanding at a pace beyond that consistent with systemic safety," and that
"preventative actions are required sooner, rather than later."The views and
opinions expressed in Bill Fleckenstein's columns are his own and not
necessarily those of CNBC on MSN Money - 1/3
2004

The next day, in a speech to the Senate Banking Committee,
he was singing a different tune altogether. Fannie Mae and Freddie Mac, the
giant providers of mortgage capital, he warned, "are expanding at a pace beyond
that consistent with systemic safety," and that "preventative actions are
required sooner, rather than later."

For a Federal Reserve chairman who has demonstrated that he
couldn't identify reckless behavior if it ran him over, it was rather
surprising to hear him chide Fannie and Freddie for their recklessness. (I
should state, however, its an opinion I tend to share.)

Before quoting from the above, I would just note that
Greenspan's latest comments reminded me of a speech he gave on March 6, 2000,
which I have dubbed "An Ode to Technology." In the speech, he waxed on about
the wonders of technology and how it had brought us a new era and all that
other stuff. Folks may not remember that date, but it was four days before the
Nasdaq Composite hit its all-time high of 5,048.62.

Despite the recovery over the past year ago, the composite
is still down nearly 60% from the March 2000 peak.

This is not the first time Easy Al has been way off. On
March 7, 2000, I wrote a column called Alan Greenspan: Friend or
Foe that chronicled some of his prior quotes, speeches and the like. It
includes his Jan. 7, 1973, utterance (right before the recession that ranks as
our worst, at least until we get through the one we're in but haven't
completed): "It is very rare that you can be as unqualifiedly bullish as you
can be now."
http://www.fleckensteincapital.com/old_raps/friend_or_foe.htm

The blissful combination of
higher growth and lower inflation that has characterized the U.S. economy since
last spring is the inverse of stagflation, the nightmare scenario that followed
the oil shock of 1973-74Still lower inflation is a distinct
possibility. John Makin AEI 29/1 2004

Since last spring, the United States has experienced the apparent happy
paradox of sharply higher growth but lower inflation. However, listening to the
persistent complaints about higher U.S. budget deficits and the uneasy murmurs
about the need for the Federal Reserve to start tightening monetary policy--not
to mention grave concerns about a weaker dollar (another way to boost aggregate
demand)--it is easy to see that many economists and policymakers are clueless
about recognizing the type of cycle we are in and how to respond to it.

The blissful combination of higher growth and lower inflation that has
characterized the U.S. economy since last spring is the inverse of stagflation,
the nightmare scenario that followed the oil shock of 1973-74, when higher oil
prices produced lower output, lower growth, and higher inflation. The current
cycle is fundamentally benign--more output at lower prices--but if policymakers
fail to recognize it as such and ignore falling prices because output growth is
strong, a global recession could occur.

A little reflection provides a straightforward explanation of the
current cycle. The old bugaboo, stagflation, reflects a backward shift of
aggregate supply to less output at each price level along a negatively sloped
aggregate demand schedule. Output falls, and prices rise. In the inverted
circumstance we see today, an outward shift of aggregate supply--that is, more
output at each price level-a-long a negatively sloped aggregate demand schedule
occurs, and the result is more output at lower prices.

Both types of supply shifts are confusing to policymakers and analysts
because most of the time growth and inflation levels are positively correlated,
with higher growth tied to higher inflation and lower growth to lower
inflation. That is because aggregate demand shifts are typically larger than
shifts in aggregate supply. An outward shift in aggregate demand results in a
new intersection with a positively sloped aggregate supply schedule at a higher
price level and a higher level of output, and a drop in aggregate demand has
the opposite effects.

During the second half of 2003, when high levels of U.S. policy stimulus
boosted demand growth, U.S. inflation and interest rates actually fell. The
Fed's favorite measure of U.S. inflation--the year-over-year core PCE
deflator--fell steadily, from 1.8 percent in 2002 to a cycle low of 0.8 percent
in November of 2003. Now the core PCE (short for "personal consumption
expenditures") deflator at 0.8 percent is below the 1 percent level designated
by Fed governor Ben Bernanke as the minimum comfort level. Bernanke pointed
this out in his talk before the American Economic Association in early
January.

Interest rates on U.S. ten-year notes have been remarkably stable since
peaking in August at 4.5 percent, following a sharp sell-off tied to a
perceived change in Fed policy with respect to purchases of long-term notes and
bonds. In fact, prior to August, two-thirds of the rise in ten-year yields
resulted from a rise in expected real yields (based on TIPS pricing), from a
low of 1.5 percent early in June to nearly 2.5 percent in August--an
extraordinary and unprecedented move in real interest rates.

If there still is aggregate excess capacity in the U.S. economy, as
suggested by the concurrence of low real interest rates and falling inflation,
what can we expect to see in the future? Still lower inflation is a distinct
possibility.

Japan and Asian emerging market economies have one thing
in common: they are desperate to keep their currencies down against the US
dollar. They would far rather lend the US the money with which to buy their
exports than endanger their competitiveness or become reliant on fickle foreign
finance. Does this behaviour make sense? Is it likely to change soon? The
answer to these questions is: Yes and, in all probability, No.

The Europeans, in particular, long for the Asians to share
in the adjustment to the weakening US dollar. This passionate desire is not
surprising. According to the February Consensus Forecasts, the current account
surplus of the Asia-Pacific region was $234bn last year, against only $35bn for
the eurozone. This makes it puzzling, at first glance, that it is the euro, not
the Asian currencies, that is soaring.

Asian emerging market economies have learnt from the
experience of 1997 and 1998 a lesson that is rather different from that drawn
by orthodox economists. The latter believe that the crisis showed the danger of
adjustable pegs. It would be better, goes the argument, to choose between
irrevocably fixed exchange rates (or, better still, dollarisation) and freely
floating rates.

The directly affected countries drew a different
conclusion. Polonius advised his son to be neither a lender nor a borrower. The
Asians decided instead that it was far better to be a lender than a borrower.

The chief explanation for this is what economists have come
to call "original sin", by which they mean the reluctance of international
capital markets to lend in the currencies of emerging economies. If such
economies become substantial net debtors in foreign currency, they become
vulnerable to mass bankruptcy or public sector insolvency if their currency
tumbles. Yet just such a collapse becomes likely as foreign currency
indebtedness grows. The solution then is to prevent the country from becoming a
net debtor in the first place.

Whatever Europeans may desire, the prognosis is that Asia
will continue to run huge current account surpluses and interfere in exchange
markets. Its governments will not lightly abandon policies that they believe
work well for the convenience of any outsiders.

The power and influence of the United States is being
overestimated, claims French historian and demographer Emmanuel Todd. "There
will be no American Empire." "The world is too large and dynamic to be
controlled by one power." According to Todd, whose 1976 book predicted the fall
of the Soviet Union, there is no question: the decline of America the
Superpower has already begun.

"A powerful antidote to hysterical exaggeration of American
power and potential by American triumphalists and anti-American polemicists
alike. A best-seller in Europe, Todd´s book should be read by all
thoughtful Americans for its provocative and well-informed analysis of their
nation and its prospects." from the foreword by Michael Lind

"The most effective and most talked about of the new
anti-American texts." Adam Gopnik The New Yorker

US government will run up a budget
deficit of nearly $500bn in 2004 - the largest in US history in absolute terms,
5% of GDPBBC 27/1 2004Highly recommended - good links

The non-partisan Congressional Budget Office says the US
government will run up a budget deficit of nearly $500bn in 2004 - the largest
in US history in absolute terms, and, at 5% of GDP, the largest since 1993 as a
percentage of the economy.

The budget deficit is now one quarter of total Federal
spending, and 80% of the total receipts from Federal income taxes.

It is equal to $1,600 per US citizen this year, and the
accumulated deficit over ten years would be nearly $20,000 per person.

SINCE September 11th 2001, it has become obvious to all
that the world is a risky place. Even before that atrocity, the world had
seemed far from safe to many, especially those concerned with business and
finance. The end of the dotcom craze and the bursting of the stockmarket
bubble had already created huge uncertainty. But those are only the most recent
examples of unexpected events that can make a mockery of people's
plans.The
Economist Survey 22/1 2004

The dogs of Davos don't bark at the real
dangerscontinuing overoptimism about Europe, a Democrat in the White
House, inflation Anatole Kaletsky, The Times January 22, 2004

This view from Davos is certainly a valuable guide, but not
quite in the way intended. Rather than pointing to where the world is going in
the next 12 months, the annual consensus established in Davos shows what will
not happen.

Last year, the message was one of profound gloom  the war in Iraq
would engulf the world in years of violence, the global economy would slide
into depression and stock- markets would suffer another collapse. In the event,
of course, the opposite occurred. Looking back, a similar pattern emerges over
the years: the view from Davos is usually a contrary indicator, at least of t House prices

he
short-term trends. In 2002, Davos expected another terrorist attack even worse
than that of September 11. In 2001, the consensus anticipated a Thirties-style
depression, triggered by the collapse of technology shares. In 1999, there was
the global peril of the millennium bug.

The view from Davos is not always gloomy, although the rich and powerful
are often very insecure about the future, presumably because their happiness is
so bound up with their power and their fortunes, which can quickly evaporate.
In 2000, the consensus was manically enthusiastic, celebrating the limitless
wealth created by the internet. In 1998, there was equally misguided jubilation
about the launch of the euro and the new economic superpower it would create.

My aim is not to suggest that the participants at Davos are purblind or
foolish, although it is true that success as a businessman or politician
requires such fanatical concentration on a single company or political project
that it is easy to miss the wood for the trees.

This, however, is not the main reason why the Davos consensus is so
often misguided. There is another problem  the very fact that these
elites are so powerful and so rich. Between them, they control most of the
worlds economic output and almost all of its military might. If they all
focus on one opportunity or one danger, then the chances are that this
particular opportunity has already been largely exploited or this danger warded
off.

It is when no consensus exists among the worlds rich and powerful
 for example, on climate change or Israeli expansionism, or the Saudi
support for Islamic terror  that the dangers fester and grow. When a
subject is not even mentioned at Davos it has maximum capacity to surprise and
therefore to change the world, for good or ill.

Last year, I was struck by three huge economic issues which Davos
completely ignored.

As I wrote here last year, the rise of the euro and its devastating
effect on Europe hardly even got a mention.

I was also amazed that nobody even bothered to talk about the
possibility that Wall Street would rebound rather than collapsing.

Finally, it surprised me that Davos paid so little attention to the
rise of the Asian consumer and the shift in global growth leadership from
America to Asia, especially China. In the event, all three of these issues
turned out to be crucial for understanding the world in 2003.

So today it seems worth asking: what are the Davos dogs not barking at
this year?

The easiest one to spot is the continuing overoptimism about Europe.
While last years indifference to exchange rates has given way to a
recognition that the euro is now dangerously overvalued, nobody seems to be
drawing the obvious conclusion. The European economy will remain completely
stagnant this year because the sharpest rise of the euro has been very recent
and will not have its full impact until the end of 2004 and beyond. Unless the
euro falls very soon and very abruptly, Europe will have no chance of sharing
in this years global economic recovery. Geopolitically this means that
the EU, like Japan in the 1990s, will be condemned to political paralysis and
irrelevance for much of the decade ahead. The Davos elites outdated view
of Europe as potential superpower looks like a big mistake.

A second case of rearview thinking concerns the US economy and the
presidential election. Nobody in Davos seems seriously to believe that America
might oust President Bush and put a Democrat in the White House. The surprise
result in the Iowa Democratic Party caucuses has increased the chances of
Wesley Clark, who I believe is the most plausible Democrat contender. Yet the
confidence in an easy Bush victory seems to extend even to people who
personally hate him. This is hard to reconcile with the opinion polls, which
show the race as a dead heat. Perhaps the faith in Bush simply reflects the
near-universal optimism about the US economy this year.

But what Davos ignores is that Americas economic problem in the
years ahead will probably be too much growth, not too little. A booming and
over-stimulated US economy will present the next occupant of the White House
with a daunting challenge: to clean up the mess made by Bush not only in Iraq
but also in the US Governments budget. The only way to do this will be to
create a national consensus for unpopular measures to raise taxes. But will any
politician be able to do this, especially after what is likely to be one of the
dirtiest election campaigns in US history?

The third, and most important, subject that is not being discussed at
Davos is inflation. Will 2004 be the year when the world moves from price
stability into an era of accelerating inflation reminiscent of the 1960s? In
America, the combination of very loose money, rapidly growing budget deficits,
devaluation, protectionism and military spending has always been a recipe for
inflation in the past. Rising oil, gold and commodity prices all point in this
direction, as does the global boom in property prices and the new bubble in
stockmarkets now being created by the US Federal Reserve.

Yet despite all these warning signs, the Davos consensus sees economic
weakness, not inflation, as the main economic peril in the year ahead. This is
exactly the situation in which inflation is likely to start. The people
supposed to control inflation  central bankers, politicians and bond
investors  are part of the global elite represented at Davos. So if Davos
ignores inflation, the same will be true of the Federal Reserve and the other
anti-inflationary vigilantes. Thus nothing will be done to pre-empt an
inflationary spiral before it takes off.

The same is true of the other dangers overlooked at Davos. If the Davos
elite is caught napping by European stagnation or by US political turmoil or by
the rising euro, the central banks and governments and other guardians of
global stability will also be taken unawares and will fail to ward off these
dangers. That is why the Davos consensus is genuinely important  and why
it so often turns out to be wrong.

This page is,Stephen Roach, chief economist at Morgan Stanley, is
more pessimistic.By keeping interest rates unnaturally low and greatly
increasing fiscal spending, U.S. policymakers have fueled the creation of a
series of bubbles in asset marketsInternational Herald Tribune 22/1
2004

Roach has been consistently bearish as the global economy
weathered the dot-com stock collapse three years ago, followed by a recession
in the United States and elsewhere and a less-than-scintillating recovery over
the last year.

By keeping interest rates unnaturally low and greatly
increasing fiscal spending, he said, U.S. policymakers have fueled the creation
of a series of bubbles in asset markets. A new one might be forming now in
technology stocks, he added.

By opening the fiscal and monetary taps, Washington
policymakers have also inflated the current account deficit, the broadest
measure of trade in goods and services. The current account shortfall has been
cited by many economists as a cause of the falling dollar; the United States
requires net inflows of close to $2 billion a day just to finance the current
account, because it imports far more goods and services than it exports.

Greed, fraud, credulity and the bull
market By Philip Coggan Financial Times; Oct 23, 2003 BULL! A
HISTORY OF THE BOOM, 1982-1999 What drove the breakneck market and what
every investor needs to know about financial cycles By Maggie Mahar
Harper Business, £16.85

The bull market ofthe 1980s and 1990s was one of the most
powerful in history. It incorpo rated all the classic features of abubble: easy
credit, mass participation, fraud and a naive belief in a "new era" that would
justify the euphoria.

Much analysis has focused on the final excess, the dotcom
bubble and its idiocies. But in the history of the bull market, this was just
the cherry on the cake. There was a lot more to the rise in share prices than
profitless e-tailers.

Maggie Mahar, one-time English professor at Yale turned
financial journalist, has attempted a more comprehensive look at the period. It
is an entertaining romp, complete with pen portraits of the heroes - bears such
as Gail Dudack and David Tice - and villains. The latter are clearly more
numerous, ranging from the anchors of the financial TV network CNBC to the
senators who in 1993 blocked an accounting standard that aimed to spell out the
true cost of executive options. On this evidence at least, we must hope that
Senator Joseph Lieberman does not win the Democratic nomination for president.
For anyone who was involved in the bull market, the book does not provide any
great new revelations. It is the incidental detail that keeps the story
motoring, such as the abusive phone calls received by internet analyst Henry
Blodget when whenever he dared question the credentials of one of his client's
favoured stocks. Blodget, made a scapegoat for the sins of the analysts'
community, emerges as a fairly sympathetic figure, a man clearly out of his
depth.

All the main issues are covered, from dodgy accounting, the
explosion in mutual funds, the belief in the new economy and the cheerleading
role played by investment bank analysts. But if there is a flaw in the book, it
is that it focuses almost entirely on the US and on the personalities in that
market. While the US was undoubtedly the home of the great bull market, a
proper history of the phenomenon would have to include Europe, where in the
late 1990s, the equity culture appeared to sweep the continent.

Risk management for the masses Mar 20th 2003 From
The Economist print editionRobert Shiller is professor of
economics at the International Centre for Finance, Yale University, and the
author of Irrational Exuberance (Princeton University Press,
2000).

His new book, The New Financial Order: Risk in the
21st Century (to be published by Princeton University Press on April 2nd;
$29.95 and £19.95), on which this
article (Risk management for the masses, Mar 20th 2003 The Economist) is based, lays out a vision for the future of finance, insurance
and social welfare.

Warren Buffett, the influential
investor, warned derivatives were financial weapons of mass
destruction and that they were potentially lethal to the
economic system. In his letter to shareholders of Berkshire Hathaway,
Mr Buffett said he and Charlie Munger, the investment and insurance
companys vice chairman, viewed derivatives and derivative trading as
time bombs. Financial
Times 4/3 2003

The boom that did not bust By John Plender
Published: February 6 2003 21:02

BBC 12 September, 2002US economic guru Alan Greenspan has warned
lawmakers that their inability to balance the federal budget threatens the
country's economic stability. Mr Greenspan, chairman of the US Federal Reserve,
urged Congress and the administration of President George W B obviously, under reconstruction, click here for old page

The dilemma facing policymakers was neatly encapsulated by the European
Central Bank (ECB), whose main governing body met on July 4th to decide what to
do about interest rates.

The ECB continues to be worried about inflation: it has often failed to
hit its inflation target (no bad thing say those economists who believe the
target is too tight), and Wim Duisenberg, the banks president, admitted
that the risks to price stability remain tilted to the upside. Yet
the ECB left rates unchanged because, said Mr Duisenberg the
uncertainties were too large to come to a decisive decision.

Since, in theory, at leastand in publicthe ECB insists that
its only target is inflation (and not, unlike Americas Federal Reserve,
economic growth as well), the principal uncertainty for Mr Duisenberg and his
colleagues is the possible inflationary impact of recent currency swings.

By themselves, falling stockmarkets do not usually cause
recessions. It is now generally accepted that the blame for the Great
Depression in 1930s America does not lie with the Wall Street crash of 1929 but
the unreasonably tight monetary policy which followed it.

Nearly a year ago, Graham Turner warned that the US economy was driven
by a huge bubble of artificially inflated profits. Writing for BBC News Online,
he explains why the Enron, WorldCom and Xerox scandals are just the tip of the
iceberg.

The recovery mythsThe world economy is coping
with the aftermath of two huge asset-price bubbles: the Japanese of the 1980s;
and the US-led worldwide bubble of the second half of the 1990s. Adjustment
to the end of the first is not yet over. Adjustment to the end of the second
has, contrary to conventional wisdom, hardly begun.By Martin Wolf,
Financial Times June 11 2002

Capitalism and its troubles SURVEY:
INTERNATIONAL FINANCEMay 16th 2002 From The Economist print edition

CAPITALISM has had a rotten time lately. Not as rotten as in 1917, when
those revolutionary shots in St Petersburg launched a form of anti-capitalism
that ended (except in Cuba and North Korea) only just over a decade ago.

Nor, with luck, as rotten as in 1929, when a stockmarket crash on Wall
Street set off the global Great Depression.

But rotten, nonetheless. Nobody knows for sure yet, but 2001 might come
to be seen as the year when two decades of mostly unbroken progress for
capitalism gave way to something more ambiguous a

Analysts sense day of reckoning for dollar: A fall
in capital inflows to the US has alarm bells ringingChristopher Swann
Financial Times; Apr 27, 2002

The key problem for the US currency is that investors do
not need to sell US assets for the dollar to fall. All that is necessary is
that they fail to buy. The bloated US current account deficit, running at about
4 per cent of gross domestic product, means that the US needs to attract a net
inflow of around Dollars 1.5bn (Pounds 1.04bn) every day in order to stop the
dollar falling. The latest figures from the US Treasury provide strong
indications that capital inflows are finally drying up. In January the net
inflow into US equities and fixed income was just Dollars 9.5bn. This is weak
even compared with the Dollars 17.8bn the US attracted in September.

There are two theories about Wall Street's role in the bubble years of
the new economy. Either investment analysts were swept up, like everybody else,
in the prospect of extraordinary gains in efficiency that the Internet would
bring, so justifying ever higher share prices.

Or Wall Street saw a golden chance to peddle dirt.

New York's attorney-general, Eliot Spitzer, is a promoter of the second
theory. On April 8th he delivered an affidavit to the state's supreme court
that paints Merrill Lynch's share-buying recommendations for Internet companies
during 2000 as little more than a pretext to stuff gullible buyers with the
shares of rotten businesses. (Big customers, meanwhile, were whispered the
truth.)

Chairman
Alan Greenspan January 11, 2002 Although the quantitative magnitude and
precise timing of the wealth effect remain uncertain, the steep decline in
stock prices since March 2000 has, no doubt, curbed the growth of household
spending. Although stock prices recently have retraced a portion of their
earlier losses, the restraining effects from the net decline in equity values
presumably have not, as yet, fully played out. Future wealth effects will
depend importantly on whether corporate earnings improve to the extent
currently embedded in share prices.

The boom that did not bust By
John Plender Published: February 6 2003 21:02

In the developed world it appears that financial crises no longer derail
economies. Even in Japan, which has experienced four years of price deflation
and where the banking system has been in crisis for over a decade, the output
loss has been minor. And now the collapse of a phenomenal stock market bubble
in the US has defied historical precedent by spawning only a modest recession
and no banking crisis at all.

There are many possible explanations for the failure of this financial
dog to bark. Much more of the risk-taking was happening outside the banking
system than in the 1980s. Banks appear better capitalised as a result of the
Basle capital regime. Most important, policymakers in the US have been acutely
aware of the risks of deflation and swift in their monetary and fiscal response
to the bursting of the bubble. Thursday's cut in UK interest rates likewise
suggests that the risks in UK policy are not being taken on the side of
deflation.

So now the politicians and central bankers are intensively managing the
business cycle, can we stop worrying about the impact of financial instability
on economic growth? Not in the emerging markets, where financial crises in
Asia, Latin America and Russia have inflicted devastating losses of output and
employment. And there is one important snag in the developed world, especially
in the English-speaking economies.

The existence of a monetary and fiscal safety net creates moral
hazard. That is, companies, financial institutions and private individuals
engage in balance sheet adventuring - an evocative phrase used by the economist
Hyman Minsky, whose thinking on financial instability and the business cycle is
particularly relevant in the post-bubble world.

Financial crises serve a purpose. In cycles that have been characterised
by debt-financed and unremunerative over-investment, the discipline of
bankruptcy ensures that debt is written down to realistic values and capacity
is brought into line with demand to pave the way for an upturn. But the
adjustment is painful.

If financial crises are eliminated, the business cycle is extended.
Asset prices continue to rise, generating wealth effects that encourage people
to run down savings and borrow on the strength of the rising value of their
collateral. As the Montreal-based Bank Credit Analyst points out, the failure
to correct balance sheet excesses in the downturn means that each new US
expansion begins from progressively lower levels of liquidity.

US household debt has gone from less than 40 per cent of gross domestic
product in 1960 to close to 80 per cent in 2002. The comparable rise for the
non-financial corporate sector has been from 26 per cent to 46 per cent. The
greater the balance sheet excesses, the more painful the corrective process
will ultimately be. So with each new cycle, say the BCA editors, the stakes
become higher, pushing the economy closer to a deflationary end-point. An end
is inescapable since debt cannot rise faster than incomes for ever.

The denouement of the debt drama is sparked by deteriorating credit
quality, which exposes the vulnerability of a banking system that hitherto
appeared well capitalised. The risk is of a 1930s-style deflation and liquidity
trap, as banks stop lending and the private sector tries to restore its balance
sheet. It was on such grounds that Peter Warburton, the British
economist, warned in a recent book - Debt and Delusion, Penguin Books -
of an explosion thatould shock the western financial system rigid.

Yet there is a problem with timing. Governments have become used to
managing the cycle and deferring the debt problem. For their part, private
individuals in the US and UK continue to be happy to borrow for home ownership
without fully grasping the extent of the repayment burden in a low inflation
era.

Many feel a high level of debt is affordable on the basis of a
one-off fall in interest rates to very low levels. Yet there is no such thing
as a one-off fall in interest rates. Throughout history interest rates have
gone up as well as down. And the debt will not go away.

So while Mr Warburton, like Noah, builds his ark, a question remains.
If debt continues to accumulate over the next economic cycle, will central
bankers and governments be able to confront an apocalyptic financial crisis by
simply muddling through?

Last week, the Federal Reserve decided to blow, once again,
into the flapping sails of the US economy. The puncturing of the bubble economy
continues to create fierce headwinds. Further interest rate cuts - perhaps more
unorthodox measures - remain likely.

The last time the Fed Funds rate was as low as this was
July 1961. The decisions to cut the rate from 6.5 per cent in late 2000 to the
lowest rate for more than 40 years underlines the devastating impact of asset
price bubbles on economic stability.

The aggressive easing of monetary policy is not the only
stimulant on offer to the economy. The rate of just over 4 per cent on 10-year
Treasuries is the lowest since 1963. Moreover, according to the Congressional
Budget Office, the fiscal stimulus this year is worth 2.4 per cent of gross
domestic product, the biggest since records began in the early 1960s.

If not for these huge fiscal and monetary boosts, a deep
recession would surely have occurred. They have also returned the economy to
reasonable growth this year, at 3 per cent over the 12 months to the third
quarter. This is much stronger growth than in other leading industrial
countries, except Canada.

The remarkable productivity record of the US economy is now
a two-edged sword. Over the year to the third quarter, output per hour in the
non-farm business sector grew 5.4 per cent. As Alan Greenspan, chairman of the
Fed, has noted: "Over the past seven years, output per hour has been growing at
at an annual rate of more than 2? per cent, on average, compared with a rate of
roughly 1? per cent during the preceding two decades."* This suggests trend
growth in the economy is in the neighbourhood of 3? per cent.

If this productivity performance is sustained, economic
growth of less than 3? per cent means rising excess capacity and downward
pressure on profitability, wages and prices. Worse, given that there is
substantial excess capacity today, still faster growth is needed first, to
bring the economy back to more normal levels.

The current account deficit has reached 5 per cent of GDP.
Absent a miraculous turnaround in demand in the big economies outside the US,
the only way this could shrink, in the short run, would be via a huge US
recession. Far more likely is a continuing rise in the deficit, with 7 or 8 per
cent of GDP readily imaginable in the not too distant future. This is how the
US is stimulating demand in parasitic economies elsewhere.

For a long time, consumer spending grew faster than
disposable income, as the household saving rate fell and borrowing increased.
In the second quarter of 1992, the household saving rate was 8.9 per cent of
disposable income. It had fallen to 0.8 per cent by the end of last year. It is
on its way back up this year, as stock market wealth has fallen, unemployment
risen and uncertainties increased. The financial balance of the household
sector went from close to plus 5 per cent of GDP in 1992 to minus 2 per cent in
the last quarter of 1999. It has still to recover.

The most damaging bubbles are those in which stock market exuberance is
accompanied by lending euphoria. This was true of the 1920s and of the 1980s
Japanese bubble.

What makes the combination so destructive is the pro-cyclical nature of
credit expansion, which causes asset prices, incomes and profits to rise in a
boom that feeds on itself. It then becomes viciously self-feeding in the
downturn, courtesy of the regulators, since banks' capital adequacy
requirements go up instead of down when credit quality deteriorates.

The surprising fact is not that /US stock/
markets have fallen, but that they remain so overvalued. Martin Wolf: The
bubble will keep deflatingFinancial Times 2002-06-19

The story is told in my chart.

This shows the Standard & Poor's composite index (deflated by
consumer prices) since the 1880s. On this logarithmic scale, the steeper the
slope the faster the rate of growth. There have been several bull markets: the
fastest rise was in the 1920s, but the longest and cumF" VALIGN="TOP">
real interest rates, which are
relevant, with changes in inflation, which may not be.

Nobody is behaving as if the expected real return on - and cost of -
capital is far lower than ever before. If this were true, surveys would suggest
lower expected returns from markets than before: the opposite is the case. In
addition, companies would sustain investment as returns fell: the recent
investment "bust" suggests just the opposite.

Either this has been a bubble the scale of which is making deflation
slow and painful, or the long-run real return on - and cost of - capital in the
US is lower than before. If it is the former, markets remain very expensive. If
it is the latter, everyone expects historically low returns.

The similarities between America's financial bubble in the 1990s and
Japan's in the 1980s have been well rehearsed. In both cases, share prices and
capital spending soared; households and companies went on a borrowing binge.
Japan, like America a decade later, enjoyed a spurt in productivity growth,
suggesting to some that it had a superior economic model.

Yet the conventional wisdom now is that the economies have taken
divergent paths since their bubbles burst. Thanks to resilient consumer
spending, America is widely tipped to enjoy robust growth this year and next.
Meanwhile, Japan is expected to languish in perpetual recession.

The recovery mythsThe world economy is
coping with the aftermath of two huge asset-price bubbles: the Japanese of the
1980s; and the US-led worldwide bubble of the second half of the 1990s.
Adjustment to the end of the first is not yet over. Adjustment to the end
of the second has, contrary to conventional wisdom, hardly begun.By
Martin Wolf, Financial Times June 11 2002

According to that wisdom, the world's largest economy is leading the
rest of the world into a durable, if restrained, recovery after a surprisingly
brief and shallow recession. Yet this may turn out to be no more than a fairy
story for frightened children. Recent falls in the stock market and the US
dollar suggest the children are unconvinced. At its closing price of 1,031 on
Monday, the Standard & Poor's 500 was only 7 per cent above its
post-September 11 low and 33 per cent below the peak reached in March 2000.
Similarly, on a trade-weighted effective basis, the dollar had lost 6 per cent
of its value since its peak on January 25 2002.

To understand the risks ahead, it is necessary to analyse where the
world economy now is in its post-bubble adjustment. Between 1996 and 2000, the
US economy generated 40 per cent of global incremental real demand (at market
exchange rates). While US real domestic demand rose 26 per cent over those
years (a compound rate of 4.7 per cent a year), output grew by 22 per cent (a
compound rate of 4.1 per cent). The difference was the rise in the US current
account deficit, to 4.5 per cent of gross domestic product in 2000.

This expansion was unsustainable and, last year, came to an end.
Symptoms of excess were, as Brian Reading of London-based Lombard Street
Research argues (Monthly International Review 115, April 2002), too much
investment, too little saving and too big a current account deficit. Behind
these three phenomena was belief in the miracle of the "new economy", as
demonstrated by asoaring stock market, huge capital inflows and a surging
dollar.

Over the past year and a half, the US economy and, given the global role
of the US, the world economy, has begun its post- bubble adjustment. Yet what
is remarkable about this period is how modest that adjustment has been.

On June 7, the price/earnings ratio for the overall stock market was
still close to double its long-run average. Measures of underlying value
suggest that the market is still more generously valued than at any period in
the past hundred years, apart from the peak of the recent bubble and in 1929.
On a trade-weighted basis, the US dollar is 35 per cent higher than in May
1995. Estimates of the real exchange rate suggest the dollar remains almost as
high as in 1985.

Last year, business fixed investment in the US was only 3.2 per cent
below its level in 2000. This year, it is forecast by Goldman Sachs to be down
only another 7 per cent. The resilience of consumption has been astounding.
Supported by rising house prices and low interest rates, 00">1925
1929

IT IS somewhere to live; but a home is also, for many folk, a valuable
asset. No wonder people love talking about house prices over the dinner table.
In this economic recovery, however, homes have done much more than shelter
people from wind and rain. They have helped to shelter the whole world economy
from deep recession.

Many economists were worried last year that the wealth loss from falling
share prices would force consumers to cut their spending. Even after the recent
recovery, American stocks are still worth 25% less than two years ago. Yet, as
falling share prices made some households feel poorer, rising house prices have
made many more feel richer. Over the past year average house prices in America
have risen by 9%, their fastest-ever in real terms.

Although American households as a whole have more of their wealth in
equities than in housing, a relatively few rich people hold the bulk of the
shares. For most people, housing is by far their largest form of wealth.
Two-thirds of Americans own their homes, and gains in the value of those assets
have encouraged them to keep spending.

John H. Makin, American Enterprise InstituteBy
the end of 2001, American debt service burdens relative to disposable income
were at forty-year highs

Between September and December of last year, real consumer spending rose
at an 8.1 percent annual rate, above the smoothed quarter-over-quarter rate of
5.3 percent reported in the GDP statistics, while real disposable income fell
at a 7.2 percent annual rate. The rush to buy homes and automobiles on
favorable terms was financed largely on credit rather than through a surge in
incomes.

Indeed, by the end of 2001, American debt service burdens relative to
disposable income were at forty-year highs, though still sustainable provided
that the economy bounces back.

At the end of last year, American households and investors believed in a
quick recovery of the U.S. economy and increased spending at a rate that will
be sustainable only if that recovery fully comes to pass.

There is still worth in valuePhilip
Coggan Financial Times, January 26 2002

It may be time to dust off that list of high-yielding stocks

Sophisticated investors sneer at the division of their profession into
"value" and "growth" schools, seeing it as the kind of simplistic
generalisation beloved of lazy journalists.

But last year, one of the simplest valuation measures available -
dividend yield - was the key to successful UK investment performance. Value
stocks, as represented by the highest yielders in the FTSE 350, outperformed
the low-yielding growth stocks by 23 percentage points. According to the
statisticians at CAPS, that followed a 30-point outperformance by value in
2000.

After all the fuss about "sophisticated" market measures such as
EV/Ebitda (enterprise value/earnings before interest, tax, depreciation and
amortisation), it may seem odd that something as rough and ready as the
dividend yield could have been so useful.

But that may simply reflect the extremes to which the market's obsession
with growth had driven valuations in the late 1990s. At the peak, according to
Credit Suisse First Boston, the price-earnings ratios of the most highly rated
stocks were 6.5 times those of the lowest-rated. That compares with a ratio of
less than 3 for much of the 1990s.

All that we have seen, therefore, is a correction of the insane
valuations witnessed during the technology bubble.

But the odd thing is that growth investors do not seem in the least bit
abashed by their battering over the past two years. As soon as the market began
to bounce in late September, they piled into the TMT (technology, media and
telecommunications) stocks all over again. Because earnings have fallen as fast
as share prices over the past two years, valuations in the technology sector
are still up in the stratosphere. According to Thomson Financial, the historic
price-earnings ratio on the sector is about 100.

So why are investors, having been once bitten by the technology bug, not
twice shy? One answer, according to Bart Dowling, director of global asset
allocation at Merrill Lynch, is that investors are not entirely rational.

His statistical analysis shows that investors are much more influenced
by recent returns than they are by long-run performance. In the late 1990s, the
returns from owning technology stocks were phenomenal. Any fund manager who was
underweight in the sector underperformed the indices and was in danger of
losing clients.

The passion for growth stocks may be reinforced by the feeling that
overall returns from equities are likely to be low in future years. An annual
return of 7 per cent or so simply looks unappetising to most investors. Growth
stocks offer stronger meat.

Value stocks, in contrast, are seen as working just once in the cycle
(as an economy emerges from recession) but are not serious long-term
investments.

Academic evidence, however, suggests that, over the long term, value
strategies such as buying companies with low price-to-book ratios tend to
outperform the market. Remarkably few fund managers have attempted to exploit
such apparent anomalies.

This may simply be a function of the lack of respect with which the fund
management community holds academics. They did not believe the academics when
they said the markets were efficient and that most active fund management is a
waste of time; they do not believe them now when they are told to concentrate
on value stocks.

Where are we now in the cycle? It is tempting to think, after two
fantastic years for value, that it is time to switch back into growth. But
bubble valuations have not entirely disappeared, even if one dismisses the
price/earnings ratio of the technology sector as a statistical fluw.prudentbear.com/bc_library_book_store4.html">Books

ke (on the
grounds that the sector has virtually no earnings). Other measures such as
price-to-sales still leave the market looking more expensive than it was in the
early 1990s.

The doom-mongers (including The Economist) who predicted a deeper
downturn have, many argue, been proved wrong. Perhaps. But what the optimists
have lost sight of is that America's recession was caused neither by the events
of September 11th nor, like every previous post-war recession, by tightening by
the Federal Reserve in response to rising inflation.

The root cause of this recession was the bursting of one of the biggest
financial bubbles in history. It is wishful thinking to believe that such a
binge can be followed by one of the mildest recessions in historyand a
resumption of rapid growth.

Remember fiscal policy? How to
use fiscal policy in a recession The Economist Jan 17th 2002

When it works, monetary policy is fine. But sometimes it does not work.
Problems arise, especially, under the circumstances that most interested
Keynes when he first developed his thinking on
deficit spending as a cure for recessionthat is, at times of low, or even
negative, inflation.

The US has gone through its own elemental sequence of shocks in the past
three years that ought to have left it in a slump at least as bad as anything
it has experienced in the postwar period.

Beginning at the end of 1998, it was hit with the financial damage from
the Asian and Russian financial crises, followed by rising interest rates, a
steep increase in energy prices, the bursting of the dotcom bubble, the sharp
fall in the equity market, the steepest drop in capital spending in decades,
the most destructive terrorist attack in history and a hot war all over the
world which, for the first time in more than a century, poses a clear risk to
US security at home.

For good measure, on the political front, it had the impeachment of a
president and an election that failed to produce a winner until the courts
ruled five weeks after polling day.

It has been, to use the current cliche, the perfect storm of economic
and political shocks. And yet, here we are, almost before we have come to grips
with recession, staring at the growing probability that a recovery is under
way.

Output began falling last March. If it stops falling in the current
quarter - and then climbs again - the entire decline in GDP will be less than 1
per cent. In other words, if the current trends take hold, it is possible that,
having enjoyed the longest expansion in its history, the US is now climbing out
of the shortest and shallowest recession on record.

Let me enter some caveats. Recovery is by no means assured, of course.

The US has not eliminated imbalances that built up in the late 1990s.
Levels of corporate and personal sector debt remain high and could act as a
drag on growth. The extent to which the capital-spending binge of the latter
stages of the expansion created an investment overhang is still unclear, with
capacity utilisation rates remaining low. Corporate profits are weak and could
act as a further constraint on an investment recovery. Stock market valuations
still look presumptuous and vertiginous. Above all, perhaps, the durability of
the productivity miracle that seemed to be behind the rapid growth of the late
1990s is uncertain, although output per hour has held up remarkably well during
the downturn so far.

But consumption has remained robust in the past year and consumers'
balance sheets have been improved by falling interest rates, rising house
prices and last year's tax rebate.

If recovery does take hold, there will be plenty of candidates for the
credit: the Federal Reserve, certainly, for cutting interest rates more
aggressively than at any time in living memory; Congress, probably, for
shrewdly ignoring the initial request of the Bush administration not to pass an
immediate fiscal stimulus and for providing tax rebates at just the point when
they were most needed. The Bush administration's original tax cut proposals -
until last April - were all long-term and it opposed the idea of rebates last
summer.

Luck has played a part too, of course. Falling oil prices have raised
consumers' spending power. Inflation has all but disappeared. There have been
no more terrorist attacks so far.

If we see a recovery as 2002 unfolds, it is possible it will not be a
particularly robust one. Unemployment may still rise, especially if the
productivity gains are maintained. And in any case, since consumption did not
fall all that much last year, it may not stage its traditional rally into the
recovery. Corporate profits will probably stay weak, and an overvalued equity
market may still hover over the economy's prospects. But in the face of a
whirlwind of adversity over the past two years, it would be remarkable if there
is any recovery at all.

To listen to much of the commentary on the US at present, you would
think there was something rotten in the very foundations of America's economic
structure. The Enron collapse, and the evident greed, corruption and negligence
that went with it, certainly point up the need for reforms to the system of
checks and balances in American capitalism.

But in condemning and setting right the weaknesses, it would be wise,
too, to pause for a while, look at what has happened to the US economy in the
past few years, and, quietly, marvel.

To an economist, the 1990s bear an uncanny resemblance to two earlier
decades: the 1920s in the United States and the 1980s in Japan. In all three
decades, technological change produced extraordinary economic growth, leading
to talk of a new era and triggering a bull market in stocks that
terminated in a market collapse-widely regarded as the bursting of a
speculative bubble.

The 1920s were followed by the Great Depression in the U.S., the 1980s
by stagnation and recurrent recession in Japan.

What will the 1990s bring? And what role has monetary policy played in
these episodes?

Economic growth during the first 10 years of each episode was remarkably
similar. Real gross domestic product grew an average of 3.3% per year in the
U.S. from 1919 to 1929; 3.7% in Japan from 1980 to 1990; and 3.2% in the U.S.
from 1990 to 2000 -- clearly, remarkable similarity.

In the two earlier episodes, what followed was very different-a major
catastrophe in the U.S., stagnation in Japan.

From the peak in 1929 to the trough in 1933, U.S. GDP fell by more than
a third, and had not returned to the 1929 peak by the next cyclical peak in
1937. In Japan, GDP fell below the initial peak level by trivial amounts for a
few quarters, plateaued for about two years, and then resumed slow but highly
erratic growth.

In the U.S., unemployment reached 25% at the trough of the depression in
1933. During the rest of the decade, 1934 to 1939, unemployment averaged 18%.
In Japan, reported unemployment never exceeded single digits. This number
understates the severity of the situation, thanks both to different methods of
recording and different national cultures bearing on employment. Nonetheless,
it seems clear that an estimate comparable to U.S. figures would never have
reached anything like 25%.

The three bull markets in stocks likewise display remarkable similarity,
even extending to the early stages of the current decline. In the six years
prior to the stock market peak, the indexes rose 333% in the U.S. from 1923 to
1929, 387% in Japan from 1983 to 1989, and 320% in the U.S. from 1994 to 2000.

The subsequent decline was decidedly less in Japan in the 1990s than in
the U.S. in the 1930s -- 55% compared to 80% from the peak to the initial
trough. However, the Japanese index remained flat throughout the 1990s. and
more recently has fallen sharply again, while the U.S. index rose rapidly from
its 1933 trough.

The quantity of money rose fairly steadily in all three of the decades
preceding the stock market peak, but at a much higher rate in the Japanese
decade -- 9.1% per year from 1980 to 1990, compared with 3.9% per year from
1919 to 1929 and 4.1% per year from 1990 to 2000 in the U.S. The higher rate in
Japan may explain why the Japanese bubble was so much more sweeping than its
counterparts in the two U.S. episodes.

The behavior in the following years differed much more sharply. The U.S.
quantity of money fell by more than a third from the cyclical peak in 1929 to
the trough in 1933. The Japanese quantity of money fell by two-tenths of one
percent in the first year after the cyclical peak, and then rose by 2.5% per
year in the next two years. In the current episode, the quantity of money in
the U.S. has already risen by more than 11% during the first five quarters
after the cyclical peak.

These differences in monetary growth are a major reason why the
contraction in the United States from 1929 to 1933 was so much more more severe
than the flat economic growth or modest contraction in Japan. They also suggest
that the current reaction in the U.S. will be far less severe than in either of
the earlier episodes.

The evidence linking the behavior of the stock of money with the
behavior of the economy goes well beyond these three episodes. Every great
depression has been accompanied or preceded by a monetary collapse-banking
difficulties plus a decline in the quantity of money-just as every great
inflation has been accompanied or preceded by sharp increases in the quantity
of money.

Central bankers, like other students of money, have learned this lesson,
which is part of the reason that there has been no repeat of the Great
Depression in the post-World-War II period despite repeated scares. The Federal
Reserve under Alan Greenspan is currently applying that lesson, which is reason
to believe that the current recession will be mild and that expansion will soon
resume.

What the future brings will depend of course on how monetary policy
evolves. While the current rate of monetary growth of more than 10% is
sustainable and perhaps even desirable as a defense against economic
contraction and in reaction to the events of Sept. 11, continuation of anything
like that rate of monetary growth will ensure that inflation rears its ugly
head once again.

However, the Fed preempted on the downturn and I suspect it will again
preempt on the upturn, so as to avoid such an outcome.

Recessions end. This one will be no exception. One can even identify the
sources of a turnround: the reversal of the worldwide collapse in manufactured
output. The question is whether this will be much more than the proverbial
dead-cat bounce. "Highly unlikely" is the answer.

To understand what lies ahead, one must start with the downturn. Not so
long ago people argued that new technology meant the end of the business cycle.
It is now evident that new technology has, instead, generated the cyclical
extremes - via the stock market bubble, the investment surge in high-technology
equipment and subsequent collapse, and the inventory cycle.

Can US consumers pull all these rusty freight cars along behind them?
With difficulty, alas. Normally, during a recession savings rates rise. This
provides the platform from which subsequent rapid rises in consumption begin.
But such a correction has not yet happened in the US.

On the contrary, US household savings remain very low, particularly
given rising unemployment and a stock market well below its peaks. Yet the
stock market is also, once again, highly valued, with a trailing price/earnings
ratio roughly double the historic average.

True, monetary policy has been loosened heroically. But the US Federal
Reserve's activism has not come through into lower long-term interest rates.

A little sunshine is breaking through the clouds of recession. That is
what equity markets are saying. The question is whether this upsurge in
optimism rests on reality or is a temporary high induced by a flood of cheap
money.

Scepticism about the wisdom of markets is warranted by experience.
Remember what they were saying about prospects for the high-technology sector
in March 2000, when the Nasdaq composite index reached 4,959, against just
1,992 on Monday.

It is equally wise to be suspicious of macroeconomic forecasts. In its
World Economic Outlook of October 2000, the International Monetary Fund
forecast world economic growth in 2001 at 4.2 per cent and the US at 3.2 per
cent. The latest consensus of forecasts suggests that the world economy will
grow by only about 1.2 per cent and the US by 1.1 per cent. Moreover, the
authoritative National Bureau of Economic Research has decreed that this
slowdown was well under way by September 11. It has now set the end of the
record-breaking US expansion in March.

The November consensus of forecasters was for growth next year of just
1.3 per cent in the world economy, with 0.7 per cent in the US, 1.5 per cent in
the eurozone and minus 0.6 per cent in Japan. Thereafter, mainstream forecasts
become more cheerful. The Organisation for Economic Co-operation and
Development forecasts growth in the OECD area of 3 per cent in 2003, with the
US on 3.8 per cent, the eurozone on 3 per cent and Japan on 0.8 per cent. The
OECDs underlying view, again close to conventional wisdom, is that the
rebound will begin in the middle of 2002.

The strength of a recovery depends on what caused the downturn. The
standard explanation would include soaring oil prices during 1999 and 2000,
tightening of monetary policy during late 1999 and 2000, particularly in the
US, and the bursting of the high-technology bubble. These changes in background
macroeconomic conditions triggered a cutback in investment, a decline in demand
for manufactured output, an accumulation of unsold inventories and then a still
greater cutback in output. In the US, for example, output of manufactures in
October 2001 was 7 per cent below its peak in June 2000.

The slowdown has become global partly because the background forces -
higher oil prices, tighter monetary policy and the bursting of the
high-technology bubble - were also global. But between 1996 and 2000, the US
alone generated just under half of total world incremental demand, at market
exchange rates. With that gone, there was not much demand dynamism left.
September 11 was merely the coup de grace.

The justification for optimism is that these conditions have changed.
Oil prices are now down about 40 per cent in real terms from their peak in
2000. Monetary policy has eased dramatically, particularly in the US, with
short-term rates down 4.5 percentage points in less than a year. With inflation
subdued, there seems to be little constraint on further monetary easing. Fiscal
policy is also becoming more expansionary, particularly in the US. Aware of
this and aware, too, of the success of the first stage of the war against
terrorism, markets have recovered strongly: the Standard & Poors 500
is up 18 per cent from its low on September 21.

All this seems to justify expectations of a fairly normal recovery. Some
optimists suggest that the quantity of monetary petrol poured by the Federal
Reserve on the dying embers of the US expansion will even generate a vigorous
resurgence.

Alas, the opposite is more likely. The view that there will be a more or
less conventional recovery rests on the assumption that this was a conventional
downturn for which conventional demand management policies are an effective
remedy. But that cheerful view could turn out to be grievously mistaken.

The case for pessimism has two elements. The first is the dependence of
the world on US demand. The second is the fear that the US is now a post-bubble
economy. The argument has been well laid out by Stephen King of HSBC
(Decline and Fall - Bubbles, Busts and Deflation). Its analytical heart
goes back to non-Keynesian and non-monetarist views of recession. A period of
unwarranted optimism can generate exaggerated asset market valuations and
equally inappropriate investment. A consequence is likely to be falling
propensities to save. These will be associated with rising indebtedness, in
relation to incomes if not to (temporarily) elevated asset values.

The US in the 1930s and Japan in the 1990s were the 20th
centurys most spectacular examples of post-bubble economies. Mr King
argues that it is particularly difficult for very large economies to grow out
of post-bubble corrections, because they cannot easily use the rest of the
world as a source of demand. The US can hardly do so today.

This description fits the US experience of the 1990s disturbingly well.
If one takes the cycle as a whole, economic growth, at 3.1 per cent a year, was
no faster than in the 1980s and far slower than in the 1960s. The stock market
reached a valuation peak never seen before in history. The share of
non-financial corporate profits in non-financial corporate gross domestic
product recovered strongly during the 1990s, only to fall back to the levels of
the early 1980s. There was a big investment surge in the private sector, while
household savings rates fell. The wealth held in the stock market soared by
$12,000bn between 1994 and 2000, equal to more than six years of normal gross
saving in the economy. Why save when the stock market does it painlessly for
you?

The US is now in what Mr King calls an unplanned recession,
one that the policymakers did not want and desperately wish to halt. This is a
correction that originates more in disappointment than in overheating. But the
correction among households has hardly begun. It is also this that easy money
is intended to prevent.

If this view of the forces at work is correct, a normal postwar recovery
is unlikely. More probable is an extended period of weak growth in private
demand, offset by a sizeable fiscal expansion but not, alas, by demand from
abroad. This then would be a limping recovery, stronger, no doubt, than
Japans in the 1990s but far indeed from the new economy of
the late 1990s.

Is this certain to happen? No. Is it likely? Yes. This story of
post-bubble correction is not yet over. It may have hardly begun.

Its time to come back down to earth
By Philip Coggan, Financial Times, October 5 2001

A share is just that - a share in the assets and profits of a company.
Its value depends on the current and future level of those assets and profits.

But for a while in the late 1990s, investors seemed to ignore those
fundamentals. They bought shares because they were going up and let the next
investor worry about things like assets or profits.

What about the professionals? When stocks were trading at 100 times
historic profits, it was pretty hard to recommend their purchase on the basis
of traditional valuation methods.

Did this mean that analysts told investors to sell such stocks? Not a
bit of it. Instead they went in search of new valuation methods that might
justify a holding in the stock.

There is a problem with many of these short cuts, however. Take the
price-earnings ratio. It may appear to provide a useful rule of thumb as to
whether a share is cheap or dear.

But the p/e is based on earnings per share, a figure which managers find
relatively easy to manipulate. To take just one example, when a company with a
high p/e uses its shares to make a successful bid for a company with a low p/e,
its earnings per share go up. This is nothing to do with whether the bid is a
business success.

In the late 1990s, many analysts shifted their attention away from the
p/e ratio and towards a measure based on ebitda (earnings before
interest, tax depreciation and amortisation). This measure was an attempt to
look at the cashflow available to service all the obligations of a company
(debt as well as equity) and allowed the comparison of companies with different
capital structures or accounting treatments.

Secondly, companies shifted to returning cash to investors via share
buy-backs, rather than dividend payments; in the US, in particular, buy-backs
had tax advantages. The UK government gave this change momentum by abolishing
the dividend tax credit in the late 1990s.

Those eight years took in a stock market bubble. This in part reflected
favourable economic trends, and especially growth in corporate profits. But the
scale of the price rise also reflected uprating. When I started writing the
column, the S&P 500 offered a dividend yield of 2.7 per cent and a
price/earnings ratio of 23, falling to 16 in 1995: at the market peak in March
2000 the yield was just 1.07 per cent and the p/e ratio had reached 35.

This bubble was often presented at the time as being created by
day-trading amateurs, but it can be better viewed as a collective mistake by
investment professionals. How did it happen? Here are a number of the themes I
discussed during the late 1990s:

U.S. payrolls plummeted in September, posting the largest drop in more
than a decade, the Labor Department said in a report that doesnt reflect
job losses after the terrorist attacks. Unemployment stayed at 4.9 percent.

Payrolls fell by 199,000 last month after declining by 84,000 in August,
as service businesses lost more jobs than factories did. The largest previous
drop, of 259,000, occurred in February 1991, toward the end of the last
recession.

This is turning into the worst bear market since 1973-74. It is not only
deep (a 37 per cent decline in the S&P 500 at its lowest close on September
21) but it has also been unusually long, with the Dow so far into the 21st
month of decline.

That compares with 23 months in 1973-74, when the total fall was 45 per
cent, and almost three years in the record-setting 89 per cent collapse between
1929 and 1932. In contrast, the peak-to-trough decline of 36 per cent centered
on the October 1987 crash was fitted into just 8 weeks.

This time it is different, as they say. In recent months the world has
been awash with liquidity, and bond yields have been relatively steady: no
problems there. It has been the valua tion error that has dominated: a vast gap
has become apparent between the incredibly optimistic future growth rate
implied by equity market levels at the peak and the rather sombre economic
reality now unfolding.

How this mistake happened is too complex a subject to discuss here now.
But some vital points are raised in a paper published this week by Bob Semple,
UK equity strategist for Deutsche Bank, entitled (with an arguably superfluous
question mark) The end of the equity cult? In particular, institutions
like pension funds and life insurance companies have accepted too much risk in
equities. The great bubb le turned out to be a disaster for risk contr Gold
ol: the
current bear market represents a restructuring of portfolios in favour of safer
assets, notably fixed income bonds.

The puncturing of the bubble now under way bears a worrying resemblance
to the post-1929 Wall Street correction and the ending of the Japanese
"miracle" in 1990. Such a comparison would fit in with the extended nature of
the adjustment now taking place: but more optimistically, we can reasonably
hope that today's governments in the US and Europe will not make the mistakes
made in the early 1930s in the US, or more recently in Japan.

Needless to say, this downwardly revised prognosis -- 1.9% average
growth in world GDP over the 2001-02 perioddepicts a world in deep
recession. After all, 2.5% growth is usually viewed as the global recession
threshold. Moreover, if the verdict ultimately falls at the lower end of our
new risk range, it would qualify as the worst global recession of the
post-World War II eraboth deeper and longer than the contractions of the
mid-1970s and early 1980s.

As The Implosion Begins . . .? Prospects
and Policies for the U.S. Economy: A Strategic View1 Wynne Godley and Alex
Izurieta Jerome Levy Economics Institute, July 2001 (rev. August 2, 2001)

The U.S. economy is probably now in recession,2 and a prolonged period
of subnormal growth and rising unemployment is likely unless there is another
round of policy changes. A further relaxation of fiscal policy will probably be
needed, but if a satisfactory rate of growth is to be sustained, this will have
to be complemented by measures that raise U.S. exports relative to imports.

The great bear - Stock markets have been in
decline since early 2000. Philip Coggan, Financial Times, September 21 2001

This is now one of the worst bear markets in history. In early trading
on Friday, the Dow Jones Industrial Average had fallen 31 per cent from its
January 2000 peak, one of the worst 10 declines the US market has experienced
since the first world war.

And the Dow has held up relatively well in global terms. In Germany, the
DAX index has more than halved since the peak in March 2000; in London, the
FTSE 100 has fallen 36 per cent since its peak in December 1999.

What has made the bear market all the more pernicious is its length. The
Dow peaked in January 2000 and many other bourses reached their highs in March
of that year. Markets have been falling, with the occasional rally, for 18-20
months. In contrast, it took only two months in 1987 for the Dow to fall from
peak to trough.

If one combines time and severity, only four other US bear markets since
1914 are more significant:

1919-21, when the Dow fell 47 per cent over 21 months in postwar
economic disruption; 1929-32, when the Dow fell 89 per cent at the start of the
Great Depression; 1939-42, when the Dow fell 40 per cent in the early stages of
the second world war; and 1973-74, when the Dow fell 45 per cent in the face of
Watergate and the oil price surge.

There have been significant effects on certain sectors in the short
term: Oliver North, speaking on CNN on Friday, said he was the only passenger
on a scheduled flight to New York.

Lower interest rates, in these circumstances, may not help. Who cares if
the return on cash falls from 3.5 to 3 per cent? At least by holding cash
investors are guaranteed the preservation of their capital.

The problem is that the valuation case is less clear cut than at the
bottom of previous bear markets. At the end of 1974, the Dow traded on a
price-earnings ratio of 6.2 and a dividend yield of 10.5 per cent; at
Thursdays close, the Dow was on a p/e of 22 and a dividend yield of
slightly more than 2 per cent.

These still-high valuations (in historical terms) reflect the excesses
of the late 1990s bull market, when it was quite common to argue that such
measures were irrelevant. The dividend yield on the FTSE 100 index, for
example, moved above the 3 per cent level this week; but this level was seen as
a floor for dividend yields until recent ye Full
text

Housing starts tumbled in the United States last month as what has
been a pillar of strength in the worlds largest economy showed some signs
of weakness. Groundbreaking on new homes and apartments fell 6.9 percent to a
seasonally adjusted annual rate of 1.53 million units in August from July.
Economists surveyed by Briefing.com expected housing starts at a rate of about
1.63 million. (CNN 2001-09-20)

UncertaintyBy John H. Makin American Enterprise Institute
October 2001

The employment report for August released in early September showed a
jump in the unemployment rate from 4.5 to 4.9 percent. Hours worked, the
broadest indicator of the path of total economic activity, fell at a 2.9
percent annual rate during July and August. That level, unlikely to be reversed
in September, is consistent with third-quarter annual growth of about minus 2
percent-i.e., a contraction of the U.S. economy-well below what had been the
consensus in early September. The employment data forced second-half growth
forecasts to be lowered while increasing the amount of expected Fed easing.

Again, before September 11, emerging signs of further excess capacity
and disinflation or outright deflation (as in Japan) promised continued
pressure on profits and further layoffs as companies attempted to cushion the
negative impact of shrinking demand on profit margins. Underscoring the global
breadth of this trend, second quarter nominal GDP growth in Japan was reported
early in September to be falling at an annual rate of 10.7 percent. Profit
growth simply cannot revive until prices stop falling, because the response to
falling prices, accelerated layoffs, will weaken demand further and cause
prices to continue to fall.

The global economic slowdown had, in short, reached a self-reinforcing
negative phase by September 11. Attempts by companies to preserve profit
margins were leading to more layoffs, which by reducing demand growth and
accelerating deflation further, produced an additional negative feedback effect
on profit margins.

Those who argue that the Dow is now a bargain may be
highly delusional. Dow Jones Industrial AverageAugust 31, 2001:
Price-to-Book: 4.61Price-to-Earnings: 26.76Price-to-Sales: 2.44
Dividend Yield%: 1.75%

Economists at the International Monetary Fund have warned of a
significant danger of a global recession along the lines of the
early 1980s and early 1990s.

A leaked draft version of the IMFs World Economic Outlook,
obtained by Financial Times Deutschland, predicts the world economy will grow
by 2.8 per cent this year but states that there could be a much deeper
and more protracted global downturn.

The focus of the IMFs concern is the outlook for the US. Although
the IMF forecasters have not changed the prediction made in April that the US
will grow by 1.5 per cent this year and 2.5 per cent next year - roughly in
line with the US administrations expectations - they see a serious risk
of a much worse outcome.

If US productivity growth is less than expected, then stock markets
could fall, triggering sharp declines in business investment and private
consumption. That would cause a global recession, and possibly
substantial financial market turbulence, including a possible
abrupt decline in the value of the dollar.

The impact of global recession and market turbulence might be
particularly severe for developing countries, the IMF economists note.

The IMFs economists argue that the impact of a US recession on the
world economy would be made more severe by the weakness of the economies of
Japan and Europe.

The World Economic Outlook is to be published ahead of the
IMFs annual meetings at the end of next month. It may be revised after it
is discussed by the IMFs executive directors next week but is unlikely to
be substantially changed.

Forget the Second-Half RecoveryBy John H. Makin resident scholar
at the American Enterprise InstituteAugust 2001

Every time I hear a typical analysis of the U.S. economy in 2001, with
its components of global recession, investment collapse, falling profits,
record deterioration of household balance sheets, and the rising need for
companies to lay off more workers, I wonder when the analysts are going to
lower their U.S. growth forecasts for the second half of this year.
Notwithstanding a positively awful set of economic conditions, most forecasts
from investment firms call for a 1, 2, 3 scenario: 1 percent growth in the
second quarter, 2 in the third, 3 in the fourth.

The easy as 1, 2, 3 recovery outlook is beginning to look
like a bad joke. It is based on the simplistic notion that 275 basis points of
Federal Reserve easing since the start of this year, together with a
combination tax cutrebate that adds about $40 billion to household income
in the third quarter, will boost spending enough to justify the 1, 2, 3
scenario.

Rather, rate cuts appear to have helped sustain a high level of
household spending on autos and housing, but one result of that sustained
spending has been a sharply elevated level of household debt.

Interest payments on consumer installment debt are soaking up 3.1
percent of disposable personal income, by far the highest level since 1968,
when a continuous data series began.

As a result, U.S. consumer installment debt is also at a record high, 22
percent of GDP, while total consumer and corporate debt has reached 135 percent
of GDP.

With debt-service burdens at record levels relative to incomes, will
U.S. households keep spending and running up more debts just because the Fed
has pushed short-term interest rates down to neutralthat is,
neither stimulative nor contractionarylevels and a check for somewhere
between $300 and $600 arrives from the Treasury this summer?

It is time for economists to quit touting a second-half recovery.
Otherwise they will look as foolish as the equity (sales) analysts
who, every week, have revised downward their earnings forecasts by 2 percent or
more as negative surprises about prospective profits have flowed
in.

The sooner analysts acknowledge that the U.S. and global economic
slowdowns are intensifyingnot abatingthe sooner policymakers,
households, and corporations can undertake necessary, realistic adjustments and
the sooner the recession will be over.

Meanwhile, an unbecoming chorus of denial is only making a bad situation
worse.

It may be that the U.S. stocktional.se/assetpricebubbles.htm">Alan Greenspan Txt
market is still overvalued, even after a
year of losses that have left all the major indexes trading well below their
historical highs of early 2000 (11,723 for the Dow, 1527 for the Standard &
Poors 500 and 5049 for the Nasdaq). The Nasdaq has been virtually
annihilated and is trading at roughly 40 percent of its peak. Among technology
companieseven those with profitsthe slaughter has been almost
universal. Microsoft is down 44 percent from its high, Intel 58 percent and
Cisco 75 percent. The bubble has burst. Game over.

Well, maybeand maybe not.

Consider the markets price-earnings (PE) ratio. The PE compares a
stocks price with the companys earnings (profits) and is a basic
tool of financial analysis. At the end of July, the PE for the entire S&P
500 group of stocks stood at almost 27: stocks were priced at 27 times their
companies recent earnings. Thats nearly twice the historical
average of 14.5 going back to 1870, according to finance professor Jeremy
Siegel, author of Stocks for the Long Run. Stocks supposedly
represent the present value of all future profits, so todays astronomical
PE must mean that either (a) despite the economic slowdown, the long-term
outlook for profits remains strong, or (b) investors are collectively
crazythe market will drop or stagnate for years because stock prices have
gotten way ahead of profits.

Gathering this weekend in Italy for their annual summit, the leaders of
the major industrial countries seem almost indifferent to the threat of a
global recession. Despite widespread prosperity -- or perhaps because of it --
economic forecasts have consistently been too optimistic.

The United States is sputtering. Growth is slowing dramatically in
Europe. Japan is in recession. Other Asian countries have been hit hard by the
U.S. slowdown. Argentina may default on its debt. The danger does not lie in
any one of these developments but rather in their convergence, which could
create a snowball effect of weakening global trade, confidence and stock
prices. The world's leaders ignore these problems at their peril.

Welcome to globalization's darker side. Connections among economies have
multiplied in ways that are only barely understood. Almost universally, trade
has grown in importance -- and it's not just trade. Early this year, Europeans
thought they would largely escape the effect of the U.S. slowdown -- a judgment
reflecting the small share (20 percent) of European exports going to America.

The logic hasn't worked. In 2000, the euro area economy grew 3.5
percent. Now, the latest estimate for 2001 from the major forecasting firm
DRI-WEFA is 1.9 percent. One reason is that more European companies have
operations in the United States. "As the U.S. economy got hit, these companies
began to scale back -- not just in the United States, but also in Europe," says
Nariman Behravesh, chief economist of DRI-WEFA.

Why it's absurd to believe investors' psychology has nothing to do with
market prices.

Mark Rubinstein and fellow academic Hayne Leland are true believers in
the efficient market hypothesis--holding that stocks are always correctly
priced, given what's publicly known about them, and that any significant
mispricings are illusions. To efficient market acolytes there is no role on
Wall Street for herd psychology, fad-chasing of initial offerings or panic
selling.

While this notion is ridiculous on its face, it has enjoyed a widespread
following through the years and has created a lot of mischief.

Well, the Dow may be the best-known stockmarket barometer, but it is
also the least reliable. It is a crude average of 30 share prices. In most
other stockmarket indices, share prices are weighted by market capitalisation.
When Charles Dow first published his index in 1896 there were no computers, so
this crude method had advantages. He simply added up the various share prices
and divided by the number of stocks.

A dollar increase in the share price of the biggest firm thus has the
same impact on the Dow as a dollar increase in the share price of the smallest
one. This is misleading, so The Economist has recalculated the Dow,
weighting shares by their market capitalisation. On this
basis, the Dow is
still down by 14% from its peak. The broader market indices, such as the
Wilshire 5000, are down by even more (see chart). In other words,
investors portfolios have suffered bigger losses than looking at the Dow
alone would suggest.

At the stockmarkets bottom in March, investors were comforted by
the fact that the Dow had fallen by less than 20%, the conventional definition
of a bear market. In fact, if it were weighted, the peak-to-trough decline
would have been almost 30%: easily good enough for a grizzly.

A depression follows a period of euphoria about the
outlook for the economy and the future earnings of "new" companies. The
euphoria becomes unsustainable, and the stock prices of the new companies
collapse. Large wealth losses replace large expected wealth gains. Consumption
growth slows, then turns negative, and stock prices of more companies fall
because weaker demand erases pricing power and, with it, prospective profits.
Demand falls further, and deflation sets in.

In a depression, the central bank discovers (to its
horror) that stock prices, not interest rates, become the major transmission
mechanism running from financial markets to the real economy. That is because
after a bubble earnings fall faster than any central bank can, or will, cut
interest rates, and when earnings, or more ominously, expected earnings, fall
faster than interest rates, then stock prices fall.

Why the US needs a recession Samuel Brittan, Financial Times,
March 29, 2001

Almost the first economic article I wrote for the Financial Times was in
response to queries about whether there would be a US recession. In fact, there
will always be a US recession on the horizon. Like most market economies, it is
prone to occasional dips; and the most one can do is to be prepared and act to
combat any downward spiral.

Is the US already in a recession? The question is semantic. If a
recession is defined as a serious fall of growth below trend, the US has been
in recession since the last quarter of last year.

What is, however, pretty clear is that significant recessions are almost
impossible to predict. This emerges just as clearly from modern work on
complexity theory, expounded for instance by Paul Ormerod, as from the more
orthodox study by Christopher
Dow , Major Recessions, 1998).

Looking at the last three international recessions, in 1973-75, 1979-82
and 1989-93, he finds that in two cases out of three the forecasting
performance of the Organisation for Economic Co-operation and Development was
either poor or a failure.

Failures are particularly likely when the recession is due to a shift in
confidence or the bursting of a financial bubble, the timing of which is almost
unknowable. The same agnosticism applies to predicting the depth and length of
any recession.

Welcome to the I-told-you-so market. Like fickle citizens who claim to
have been freedom fighters after the totalitarian regime falls, US stock market
commentators have rushed to demonstrate in recent weeks how they spotted the
collapse coming.

With exquisite timing, Warren Buffett, one of the few US investors who
can claim to have been part of the resistance all along, released his letter to
shareholders of Berkshire Hathaway, the investment company he heads, last
Saturday, on the first anniversary of the Nasdaq Composite's peak. A new wave
of investors had learnt some very old lessons, he wrote: "First, many in Wall
Street - a community in which quality control is not prized - will sell
investors anything they will buy. Second, speculation is most dangerous when it
looks easiest."

Right now, nobody believes speculation is easy. The Nasdaq is down more
than 60 per cent from its high of more than 5,000 and concern about the US
economy has infected the wider market. The Wilshire 5000, the broad-based
index of all publicly traded shares that Alan Greenspan, the Federal Reserve
chairman, is said to watch, is 27 per cent below its peak. This week, the
Standard & Poor's 500 joined it in bear market territory, down more than 20
per cent from its high, and the Dow Jones Industrial Average dipped below
10,000 for the first time in five months.

The headline-grabbing slump in the main indices prompted even the
president to worry publicly about US investors' well-being this week. "I'm
concerned that a lot of Americans' portfolios have been affected," President
George W. Bush said during a visit to New Jersey on Wednesday, but added: "I've
got great faith in our economy."

Mr Bush is not the only influential figure weighing up the stock market
on one hand and the economy on the other. Mr Greenspan and his colleagues at
the Federal Reserve will have to pay attention to both next week when they meet
for the first time since the end of January to discuss monetary policy.

"The US economy, while it has certainly slowed down considerably, has
not fallen off a cliff," says Alan Skrainka, chief market strategist at St
Louis-based Edward Jones. "The Nasdaq is down 60 per cent but the US economy
isn't."

Employment, retail sales and housing data released in the last two days
indicate that the economy is stalling rather than diving into recession. The
University of Michigan's consumer sentiment index - which most analysts had
expected to fall further in March - rose slightly, according to figures
circulated yesterday.

"Clearly we see some slowdown but we don't see a recession, by any
means," says Deborah Cannon, president of Bank of America in Houston, Texas.

But so far there are surprisingly few signs of outright fear in the
marketplace. Investors have poured more money into money market mutual funds
but, according to anecdotal evidence, they have not started to flee equity
funds. Treasury bonds - the traditional haven of risk-averse investors - have
risen as the stock market has declined but there is little indication of a
headlong rush to quality as there was in 1998 when the Russian financial crisis
and collapse of Long-Term Capital Management precipitated a global liquidity
crunch.

Policymakers are conscious of the risks. Lenders and their supervisors
"should be mindful that in their zeal to make up for past excesses they do not
overcompensate and inhibit or cut off the flow of credit to borrowers with
credible prospects", Mr Greenspan told a banking conference this month.

Unfortunately for equity investors, Tuesday's Fed decision will be only
NT>

There were plenty of smiles at a cocktail party hosted by pension fund
managers Phillips & Drew at the Eastbourne investment conference of the
National Association of Pension Funds this week.

Its "value" investment style has been prospering again, and although the
firm lost a lot of clients last year, this month it has retained a 2bn
management contract with the Greater Manchester local authority pension fund.

Yet it is only twelve months since Tony Dye was forced out as Phillips
& Drew's investment director. Attaining notoriety as London's Dr Doom, he
had been bearish for too long during the extended and extreme bull market.

The timing of his exit turned out to be perversely precise: within days
the global stock market bubble reached its peak of over-inflation and America's
Nasdaq Index subsequently collapsed 60 per cent.

More significantly, the broad S&P 500 Index was down 24 per cent at
its low point this Wednesday. London's FTSE 100 Index declined by a slightly
more modest 19 per cent.

Now Tony Dye is launching the Contra Fund, a European hedge fund in
which he can not only accumulate the shares of his beloved value companies but
he can indulge in the additional pleasure of short-selling overpriced growth
stocks.

He may, though, require a better sense of timing than he showed at P
& D.

Waking up to equity riskCan the
global equity culture survive its first bear market? Mar 8th 2001 The
Economist

WE ASK all our readers to observe a one-minute silence on March
10th to mark the first anniversary of the Nasdaq peak. Over the
past year this index, once the beacon of Americas new economy, has tumbled by
55%.

Americas broadest stockmarket index has lost more than 20% of its value.
Markets around the world are now, on average, at least one-fifth below last
years peak, as share prices have also tumbled from Tokyo to Frankfurt, Sao
Paulo to Seoul.

Over the past year, around $4 trillion has been wiped off the value of
American shares alone, a sum equivalent to 40% of the countrys GDP.

The collapse in share values after the stockmarket crash of 1987 was
only half as big, at 20% of GDP. Welcome to the global bear market, the
grizzliest for a generation.

Nowadays, falling share prices hurt economies more than they used to
because stockmarkets are everywhere much bigger not just in absolute terms but
also in relation to national income. As a result, Americas economy may yet face
a recession that was not supposed to happen (see article).

But is even more at stake than the course of the business cycle in the
United States and elsewhere? Might the fall in share prices spell the end of
the publics passionate new fondness for equities? If so, that would be a more
significant change than you might suppose.

The 1990s will be remembered as the start of the Internet age, but also
the decade when the worldnot just Americadiscovered shares. Global stockmarket
capitalisation hit $35 trillion last year, 110% of global GDP, up from 40% in
1990.

Stockmarkets used to be seen as the reserve of pinstriped brokers and
their wealthy clients. No longer. Over half of all Americans now own shares,
twice as many as on the eve of the 1987 crash. Share ownership is even higher
in Australia, an economy which not so long ago was run by trade unions.

In Germany, where cautious investors used to put their money in bonds,
one-fifth of adults are now shareholders, twice as many as three years ago.
Even poor countries, even communist onesChina is bothhave become crazy for
shares.

Will the slump in share prices kill this emerging equity culture?
Plainly, it depends on how much worse, if at all, the share-price slump gets,
and how quickly it is reversed. Share prices might recover as swiftly as after
the crash of 1987. But by many traditional yardsticks they remain overvalued.
And just as stockmarkets overshoot at the top, they often undershoot at the
bottom.

After an 11-year bear market in Japan it is hardly surprising that less
than 10% of households still own shares. Here, too, a rapidly ageing population
poses a big challenge to pension finance. In the short term, on the other hand,
a severe bear market would make it even harder to privatise state-run
social-security systems, such as Americas.

Meanwhile, companies are struggling to cope. The supply of fresh equity
capital has more or less dried up in America in recent months. This has had
severe consequences further down Americas capitalist food chain, because
venture capitalists rely on the exit route of an IPO to get their money back
(ideally multiplied many times over).

Entrepreneurs with bright ideas are finding it hard to raise fundsa
state of affairs that could do serious harm to prospects for further
innovation. Small individual investors, especially, have lost some of their
enthusiasm for equities.

In America, day trading over the Internet is not the national pastime it
was; these days it is regarded more as a mild form of mental illness. Actually,
that is no bad thing. Small investors need to take a cautious long-term
approach to the stockmarket.

With luck, the new equity culture will survive, but with added wisdom.
The popularity of shares ought to reflect the underlying profitability of the
companies that issue them, not delusions of instant riches at no risk.

It ought to be guided too by something closer to intelligent analysis
than the comments of one American dotcom analyst this week. Asked to explain
why his recommended stocks were down 79% since the start of last year, he
replied: The market went from saying, We like companies that are growing
quickly but are losing a lot of money, to saying, We want to see earnings. Its
very hard to predict a 180-degree turn like that.

Actually, it was dead easy to do so.

Enough of a bear market to discredit the dispensers of such drivel can
only be salutary.

IS THE flurry of gloomy economic news in America giving you nightmares?
Fear not. According to a recent survey, only 5% of economic forecasters predict
that the American economy is heading into recession. But before you drift back
into a peaceful slumber, remember that the dismal scientists have a dismal
record in predicting recessions. Not only are their forecasting tools blunt,
but many also seem to have an inbuilt bias against uttering the dreaded R-word.

Consider forecasters record during Americas past two
recessions. In late 1981, when we now know that the economy was already in
recession, the average forecast for GDP growth in 1982 was over 2%. In the
event, output fell by 2%. In August 1990, the very month that America dipped
into its next recession, the consensus forecast was for 2% growth in 1991;
output actually declined by 0.5%. By chance, the average forecast for growth
this year is again close to 2%. But, of course, this time is different: the
forecasters couldnt possibly blunder again. Could they?

To be fair, economic forecasting is even harder than weather
forecasting. At least weathermen know whether it is hot or freezing right now.
Economists, in contrast, have to forecast the immediate past, which is
constantly being revised. However, there are also much less excusable factors
at work, such as the tell em what they need to hear syndrome
or the wimpish tendency to run with the gang. Predicting a recession is never
popular, especially if you work for an investment bank. Economists who do not
want to jeopardise their career may prefer to stay close to the consensus
forecast. Better to run the risk of being wrong in good company, they reckon,
than be right and an outcast.

There have long been suspicions about the objectivity of research done
by investment-bank analysts, who, even as the ceiling falls in, advise their
clients to buy, hold or accumulate
(apparently different from buy or hold) rather than
sell. Coincidentally, these banks earn fat fees for flotations or merger deals
from the companies they analyse. Investment banks, which have made billions out
of the boom, also have a vested interest in remaining bullish about the economy
at large. Most Wall Street firms are still officially forecasting no recession
in America. But an alarming number of their economists have privately admitted
to The Economist that they believe that the risk of recession is higher than
their published forecasts say. They are not alone in their dishonesty.
International organisations such as the IMF are no doubt just as inhibited
about forecasting a recession in the country that is their biggest shareholder.

So as not to alarm their clients, economists are also swiftly redefining
a soft landing. A few months ago this was widely viewed as growth
of around 3%. Today, many economists, reluctant to admit they were wrong, are
counting anything short of outright contraction as a soft landing. Shame on
them: a slowdown in growth from a rate of 5% early last year to, say, zero this
year would certainly feel like a hard landing.

Economists can always quibble about what recession means.
The popular definitiontwo consecutive quarters of declineis too
crude. It might make more sense to define a recession as a period when the
unemployment rate rises by at least one percentage pointthat is, when GDP
growth falls significantly below its potential rate. Alternatively, there is a
less technical solution. When your neighbour loses his job, its a
slowdown. When you lose your job, its a recession. When an economist gets
sacked, thats a depression. Economists afraid to say what they think
deserve to be a bit depressed.

"One of the most striking features of the present chapter in stock
market history is the failure of the trading community to take serious alarm at
portents which once threw Wall Street into a state of alarm... Traders, who
would formerly have taken the precaution of reducing their commitments just in
case a reaction should set in, now feel confident that they can ride out any
storm which may develop. But more particularly, the repeated demonstrations
which the market has given of its ability to 'come back' with renewed strength
after a sharp reaction has engendered a spirit of indifference to all the
old-time warnings. As to whether this attitude may not sometime itself become a
danger-signal, Wall Street is not agreed." The New York Times (Sept. 1,
1929)

"The economy is showing secular productivity growth of a magnitude not
seen in decades. Inflation remains under control. The U.S. boasts budget
surpluses as far as the eye can see. The build-out of the Internet, so rich in
promise, is still in its embryonic stages. The stock market excesses of early
this year have largely been purged from the system, without exacting any
systemic damage. In short, the Goldilocks economy is alive and well and the
bull rules." Barron's (August 28, 2000)

Martin Wolf, A testing year for the worldFinancial Times, January 3, 2001-01-03

This is, for the purist, the first year of the third millennium. As
befits such a year, it will be a challenging time for the world economy.

The first test is for Alan Greenspan.

Views on the chairman of the US Federal Reserve fall into two camps. The
larger one believes his institution has mastered macro-economic fine-tuning.
The smaller camp believes he has helped create a bubble economy.

If the growth of US demand slows smoothly to about 3 per cent, with no
big declines in the stock market and a modest depreciation of the dollar, the
first group can feel vindicated. If not, it cannot.

The second test is of the new economy.

Not long ago, believers thought that the business cycle was dead,
profits were irrelevant to technology companies and the US was in the middle of
an unparalleled technological revolution.

2000 gave the lie to the first two propositions. But what is the
plausibility of the third? Even the Organisation for Economic Co-operation and
Development accepts that the potential rate of growth of the US economy is 4
per cent. This implies long-term growth in labour productivity of a little
below 3 per cent, close to double the 1973-95 trend. If so, productivity growth
should remain robust even during this years slowdown.

The third test is for the US stock market.

Those who believe that the US miracle is just another bubble economy
point to the extraordinary valuations in the stock market. This, they insist,
generated unsustainably high rates of private sector investment and
unsustainably low rates of private sector savings.

At minus 11.6 per cent, total returns on US stocks last year (with
dividends reinvested) were the lowest since 1974. Yet even this was but a
modest offset to the staggering 270 per cent cumulative return enjoyed over the
previous five years (a compound rate of 30 per cent a year).

If the bubble story is right, last years negative return will be
followed by more miserable years. If not, returns will soon be back to
positive, albeit presumably more modest, levels than in the second half of the
1990s. What happens in 2001 will indicate which it will be.

The fourth test is for the euro.

Launched with optimism, it spent almost all of its first two years
sinking abjectly against a currency its founders had hoped it would rival.
Finally, towards the end of 2000, the euro began to show some strength as the
US economy weakened, bouncing back from a low of $0.83 on October 25 to $0.94
by the end of the year. 2001 will indicate whether this is a durable reversal
or a temporary respite for what one analyst rudely labelled a toilet
currency. If the former, the euros proponents would feel great
relief. The European Central Bank would also enjoy greater freedom of manoeuvre
in response to a sharp slowdown than if the currency had continued to remain
weak.

A fifth test concerns unemployment in the euro-zone.

After years of high and rising unemployment, the trend started to turn
in 1997. Since then the unemployment rate has fallen from a peak of 11.7 per
cent in 1997 in the euro-zone as a whole to 8.9 per cent in October 2000.
Employment rose from 118.5m in 1997 to an estimated 125.4m last year. The test
for the European economy is whether it can continue to generate jobs and lower
unemployment. This depends partly on how far the ECB stabilises the economy but
also on whether the recent rise in the employment-intensity of growth will be
sustained.

The sixth test is for Japan.

Here, yet again, there are polar views: one is that the economy is
finally on the mend; the other is that it remains on the critical list, with
the semblance of vitality solely explained by unsustainable fiscal
transfusions.

The optimistic view of Japan rests on an expected recovery in
consumption along with increasingly strong investment driven by the adoption of
information technology and the need to replace outdated capital. This will more
than offset the weakening of the external account as the US economy slows.
Meanwhile the fiscal deficit is set to remain unchanged: the OECD forecasts
general government financial deficits at about 6 per cent of gross domestic
product over the next two years.

The counter is partly that the financial sector remains very weak.
Worse, just as inflation makes the profitability of net debtors appear worse
than it is, so deflation makes it appear better. Smithers & Co, a
London-based investment adviser, estimates that the true return on
non-financial corporate equity was 2.7 per cent in fiscal year 2000, not the
published figure of 6.5 per cent, hardly the ideal backdrop for a needed surge
in investment.

The underlying challenge remains that of balancing demand with potential
supply. This is an economy with a gross national savings rate of about 30 per
cent of GDP but it also has a declining labour force, an unprofitable corporate
sector and an exceptionally high ratio of capital to GDP. A return to recession
this year would force policymakers to try something radically new.

The seventh test is for emerging market economies.

Russia is particularly intriguing. Goldman Sachs estimates economic
growth last year at 7 per cent, after 3.2 per cent in 1999. True, this is a
modest turnaround given the huge decline of 44 per cent in the (admittedly
defective) measures of GDP between 1989 and 1998. Yet it is at least a sign
that the bottom has been reached. Another such year would suggest that the
TxtTxt< recovery is more than a temporary reversal helped by a jump in oil prices.

Also important this year will be whether Turkey remains on its exchange
rate peg, how Latin America, particularly Mexico, copes with a US slowdown and
whether east Asian economies dependent on US markets are able to sustain their
recoveries from crisis. More broadly, the ability of emerging market economies
to survive a slowdown in the US will be the clearest possible test of how far
they have strengthened after the financial crises of the 1990s.

My last test is for the UK.

Here everything looks almost bewilderingly healthy, with a strong fiscal
position, robust currency, low inflation, modest unemployment and a manageable
current account deficit. The International Bank Credit Analyst even described
the country as a safe haven in its December review. A turbulent 2001 would show
whether the economy has been transformed or not.

Yet 2001 will be first and foremost the testing year for the US. Is the
world about to witness the popping of a bubble economy or a smooth adjustment
from temporary overheating to sustained and rapid growth? If, after a
record-breaking nine years of expansion and a modest slowdown the US takes off
yet again, we can reasonably conclude that the notion of a new economy is more
than mere fools gold.

The governor of the Bank of England, Sir Edward George: "it's not a
nightmare scenario"

The governor of the Bank of England, Sir Edward George, has warned that
the United Kingdom is likely to be affected by the economic slowdown in the
United States. BBC 2000-12-29

He said the current data did not suggest anything "deeply damaging to
our situation" and that it was "too soon to become seriously concerned", but
warned the "biggest cloud on the horizon" would be "a sharper slowdown in the
United States than we expect".

"We will see slower growth than we expected", Sir Edward said, "but it's
not a nightmare scenario".

Sir, Prof Rudi Dornbusch has it half right (A rendezvous with
bankruptcy, December 15). The US does matter - and he glosses over the
extent of our problems. Yes, Japan is in parlous circumstances and yes, unless
they let their debts liquidate and markets clear, there is no solution on the
horizon.

US indebtedness is a much bigger problem. It now exceeds Dollars
2,600bn. The vaunted US surplus is a chimera, as the Federal budget is in deep
deficit. Why? The unfunded Social Security and Medicare obligations of the US,
coupled with unfunded government workers retirement, are a black hole. If
there were an actuarial requirement to provide for these obligations, the US
budget would show a deficit by one reckoning that pushed Dollars 1,000bn a
year.

The purported surplus is due primarily to capital gains
taxes and exercise of options by the USs senior executives. The gap
between average worker and CEO has never been greater, at a ratio of 475 times,
as a result of options.

Before 1995, Nasdaq and personal consumption in the US had a weak
correlation of 0.24. Since 1995, this correlation has increased to 0.74. As the
Nasdaq bubble further collapses, a negative wealth effect will occur, lowerin/A>
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corporate profits, wage gains and capital gains.

The US savings rate will increase from a negative rate currently,
resulting in diminished US profitability. Rising joblessness means more
government payments. Presto! Lo and behold, the deficit reappears.

Since 1995, broad money in the US expanded by Dollars 2,600bn and total
credit by Dollars 9,300bn, yet nominal GDP was up only Dollars 2,700bn. In the
second quarter of 2000, credit expanded by Dollars 1,400bn, a record pace.
Credit has been growing at 4-5 times the rate of GDP growth. Consumer credit
has never been greater, mortgage indebtedness as a percentage of total housing
value has never been greater and US corporate indebtedness has exploded as US
executives have bought back shares to make their options profitable. Downgrades
by credit agencies, rising personal and corporate bankruptcies and wide credit
spreads indicate a systemic credit problem. Pimcos Bill Gross said to
avoid corporates at any cost. Profit downgrades increase daily.

The US debt situation and credit bubble make Japan look prudent
fiscally. No amount of Fed legerdemain can overcome the collapse of the
greatest credit bubble in history.

Back in the early 90s, global interest long-term rates - as measured by
our IRS index, weighted for outstanding global OTC positions and adjusted into
USD - were in excess of 10% as the UK attempted to cool the Lawson Boom, the
Bundesbank was making Helmut Kohl pay for his 1 Ost = 1 West decision,
Greenspan was pricking the latest debt bubble in the US and Mieno was all-too
successfully restoring sanity to Japanese asset markets.

Rates then halved as the ERM crumbled, Japan imploded and Americas
banks began to domino. Soon, however, bust began to turn again to boom, and it
was time to lurch onto the other side of the boat in an attempt to keep it from
capsizing under the weight of its own contradictions. The Feds 1994
tightening - and the associated leveraged and structured derivative cascade -
took us screeching back over 8% before Mexico collapsed and Japan begun to pump
dangerous amounts of liquidity into the system in order to reverse the
Yens debilitating rise.

Then the Bubble began in earnest and interest rates embarked upon a
fairly uninterrupted decline to their nadir of 3.8% in the early Spring of last
year. Not only was this unprecedentedly low, for the modern age at least, but
it represented a global zero real rate if we compare it to OECD composite
indices and it came at a time when the ability to manufacture credit had
received an enormous (and still only dimly-understood) fillip from the launch
of the Euro and the consequent consolidation of European banking and capital
markets......

Faced with unrelenting bad news, the U.S. corporate-bond market is
staggering through its worst period since the bleak days of 1998.

Though it had been a strong year for corporate bonds until recently,
investors' losses have mounted of late, corporations are finding it difficult
to sell their bonds and Wall Street dealers are becoming gun-shy about trading
them for fear of getting stuck with bonds while prices are falling.

If the problems get worse, the U.S. economy could feel the pinch as
companies find it difficult to raise financing.

Treasury securities, the safest bonds, still sell like hot cakes (they
rallied Tuesday as stocks continued to fall). But other, riskier bonds suddenly
are struggling. Taking the biggest hit: junk bonds, otherwise known on Wall
Street as high-yield bonds, a major source of capital for many growing
companies that pose a higher credit risk. The proportion of junk bonds trading
at distressed prices surged during the past month to the highest level since
the early 1990s, when the market was paralyzed by recession and the collapse of
Drexel Burnham Lambert.

Nearly one in four junk bonds is trading at distressed levels, defined
as yielding 10 percentage points or more over Treasurys, says Martin S.
Fridson, chief high-yield strategist at Merrill Lynch & Co. The distress
ratio "is a leading indicator of the default rate [for corporate debt], so it
suggests some further pain coming," Mr. Fridson says.

Tuesday morning, Gary Goodenough decided to sell $12 million of
top-rated corporate bonds, which normally would be a snap for a professional
money manager. Not now. When he picked up the phone and asked six Wall Street
dealers for bids, two passed. Three made bids that weren't close to the market
price. The sixth gave an initial price indication, but said he would only buy
the bonds at a lower level.

A year ago, Mr. Goodenough would have hung up the phone. Tuesday, the
co-head of fixed-income investments at MacKay Shields Financial in New York
said, "Sell 'em" to the sixth dealer. Even though he wasn't happy with the
price, Mr. Goodenough was relieved to get out of his position amid a tumbling
corporate-bond market -- where it suddenly has become much harder just to get
in and out of positions.

"There's been a massive erosion of liquidity," says Margaret Patel,
manager of the $120 million Pioneer High Yield Fund, referring to the ability
of investors to easily get in and out of bond positions without moving prices.

The average junk bond is trading at 80.65 cents on the dollar, down from
more than 84 cents in early September, and almost 90 cents at the beginning of
the year, according to Merrill Lynch. Junk bonds now trade at their lowest
level since March 1991.

Wall Street is rediscovering fearthis week in its high-tech
stockmarkets, but more particularly in the junk-bond market THERE is trouble
brewing in the worlds capital markets, especially at their most
speculative end. Although the blue-chip Dow Jones Industrial Average has fallen
by only a bitwell, 10% actuallythis year, Nasdaq, the main market
for high-tech shares, has had a torrid time. Since its high point in March, it
has fallen by some 40%, and it shows few signs of hitting bottom. The profits
of technology companies are failing to meet expectationsand even the rare
ones that do, such as Yahoo!, find that this is not always enough to spare
their share price a beating. Telecoms firms are saddled with huge debts.
Internet firms are near-untouchable. At mid-week, the Nasdaq Composite index
had fallen for 13 of its 15 most recent trading days.

So much for shares. But an even scarier story may be unfolding in a
market mostly ignored by those who day-trade Nasdaqs dreamy paper: that
for corporate debt. In recent weeks, disappointing profits have meant that some
blue-chip companies have seen their investment-grade debt pummelled. The
victims include Xerox, Eastman-Kodak, and just about every telecoms firm
(death, taxes and the long-term deterioration of the phone sector are
among the few certainties in life, wrote Credit Suisse First Boston in a
recent report).

After announcing bad results, yet again, last week, the spread on
Xeroxs bonds over Treasuries tripled to 330 basis points. Hitherto,
investment-grade bonds had generally stood above the fray. Cowboy junkies The
fray has, in particular, surrounded those bonds without an investment-grade
rating: described by Wall Streets marketing folk as high-yield
bonds, but formerly (and perhaps again) known simply as junk.
These bonds, particularly those issued by non-blue-chip telecoms and tech
companies, have been by far the worst of a poorly performing bunch. Merrill
Lynchs high-yield index is now nearly as ugly as in 1998, during the
panic over the failure of Long-Term Capital Management (LTCM), a hedge fund
that owned lots of junk

This week, some big investment banks were rumoured to have lost a
fortune$1 billion is the gossips favourite sumon junk debt
they underwrote but could not shift even to their most gullible customers.
Among the names bandied about in the market were Morgan Stanley Dean Witter,
Deutsche Bank and CSFB. Each denied, more or less, that it had lost lots of
money on junk debt.

Investment banks hold many billions of dollars of debt and have lots of
risky loans on their books. One market participant reckons that there is,
perhaps, $25 billion at serious risk in the big investment banks
portfolios. It is conceivable, he says, that among them, they could lose $10
billion of this. If so, the grim reaper seems likeliest to be the telecoms
sectorwhich is fast looking less like the foundations of a glorious
Internet future and more like another outing for the emperors new
clothes.

The largest bond fund manager in the world is warning investors to
avoid corporate bonds at all costs. Financial Times 2000-10-18

William Gross, managing director of Pimco, the Allianz-owned US fund manager,
fears the US economy is heading for hard landing and says the current
environment for the fixed income markets is the most uncertain he has seen
since he began trading in the 1970s.

"Spread product [corporate debt] is in for some grim reapings in the
next month and the next few quarters," said Mr Gross, whose fund manages about
$200bn in assets, and is considered the most influential in fixed income
markets.

The fund manager's comments, at a New York dinner, have added to the
considerable gloom that has descended on the corporate bond market in recent
weeks. It has been hit by falling share prices and concerns that the economy's
growth may be slowing more than expected as default rates rise.

Corporate bond spreads have widened dramatically in a variety of sectors
as a result, drawing comparisons from some analysts to the crisis that swept
credit markets after Russia's default in late 1998.

Mr Gross has recently moved much of his portfolio into mortgage-backed
securities, such as debt from Ginnie Mae, the home lending agency. Such bonds
offer higher credit quality than corporate debt, and higher yields than
traditional Treasury bonds.

Bankers are hopeful that a $7bn offering from Unilever will be completed
this week despite the market turmoil. The Anglo-Dutch consumer products company
will use the funds for its acquisition of Bestfoods.

Nordstrom's, the US department store chain, however, has been forced to
sweeten terms of an expected $250m offering as investors have grown more wary.
Underwriters were marketing the deal earlier in the week to yield 250 basis
points over Treasuries. But investors say the spread may now exceed 300 basis
points.

The American
Enterprise Institute for Public Policy Research is dedicated to preserving
and strengthening the foundations of freedom - government, private enterprise,
vital cultural and political institutions, and a strong foreign policy and
national defense  scholarly research, open debate, and publications.
Founded in 1943 and located in Washington, D.C., AEI is one of
Americas largest and most respected think tanks.

A stock market bubble exists when the value of stocks has more impact on
the economy than the economy has on the value of stocks.

The U.S. stock market bubble is bursting - hot sector by hot sector,
starting with the Internet bubble, which has already burst, and continuing with
the information technology communications (ITC) sector bubble, which is in the
process of bursting.

The collapse of the hot sectors has also pulled down the stocks of
brokerage houses and banks that have been cheerleading for and financing those
sectors. Finally, the contagion will spread to more basic stocks such as Home
Depot, whose shares dropped sharply after announcing an earnings disappointment
in mid-October.

The collapse in 2000 of the hottest sectors of the stock market will
probably spread to other sectors and could well cause a U.S. recession next
year and possibly a global recession.

Momentum was the great theme in the global bull market in equities,
which finally appeared to peak last March. The downturn began a little earlier
outside the technology-based sectors (though there were signs of a double top
in some countries early in September). Now a Middle East war threat reminds us
of event risk of the kind that last hammered the stock market in 1990.

During the bull market, investors chased the fashionable stocks and
sectors ever higher. Those people looking for basic value and recovery
potential usually did very badly.

In the uptrend it did not matter that there was no conventional value to
justify the scarily high prices of high fliers. Now there is no value to
support their sinking prices.

The Nasdaq Index, in which became concentrated much of the US stock
market's value, but also most of the risk, has fallen by 25 per cent since the
beginning of September.

Asian markets have already entered a substantial bear market, with Tokyo
down by 26 per cent and Taiwan off by 42 per cent since peaks last spring. The
Nasdaq has declined by 39 per cent since the early March top.

The stock markets have arguably been driven by a remarkable, but
unsustainable, burst of corporate profits growth. Earnings per share growth in
2000 is expected by analysts to be 16 per cent in the US, 20 per cent in Japan
and 25 per cent in Continental Europe.

Even in the better-performing markets the earnings bonanza is
unsustainable. The US market is already being undermined by important
individual company downgrades, ranging from Intel to Home Depot.

Then there are the credit markets, which can also usually be relied upon
to send up some smoke signals of trouble just ahead. Admittedly the banks, and
their regulators, are determined not to repeat the regular past mistakes, which
have usually been concentrated in the real-estate sector.

But it is complacent to rely on lessons from old crises; the next
problem usually emerges from a totally unexpected direction. This time it is
the new-economy sector, especially tele-communications. Junk bond spreads over
government bond yields have been widening, and the ability of telecoms
companies (even substantial ones) to refinance temporary bank borrowings
through the bond market is suddenly in doubt.

We can see a classic pattern here, as repeatedly rehearsed in real
estate in the past. At one stage, in the middle of the bull market,
entrepreneurs and investors are obsessed with growth. The more grandiose the
ambitions, the better. Mobile phone giants are paying out something over $100bn
to European governments this year, just for the rights to use extra parts of
the radio spectrum. This is a symptom of over-investment; then the
realproblem turns out to be one of overcapacity.

This week Motorola, one of the mobile phone leaders, warned of a
slowdown. The company's already weak share price crashed further, and is now
down 66 per cent from the peak.

Throughout the technology sector it is time to ponder on the longer-term
consequences of such meltdowns: not just whether it will become difficult to
finance negative cashflows but whether it will prove possible to retain key
staff when the stock option plans become worthless.

Beyond that, the threat is that the whole process of leveraging
companies, partly through stock buybacks, concentrating the growth potential
into equities but offloading downside risk into bonds and bank credit, may come
unstuck.

In the US, credit quality has already been deteriorating during the
boom. Much worse could happen if there is a serious economic slowdown
aggravated by an oil famine. So far, however, there is little sign of any loss
of confidence in the banking sector - though banks stocks wobbled on Thursday.
Banks are viewed by investors as secure alternatives to the dangerous tech
wrecks. Mostly, the scare stories have been confined to investment banks, which
may have suffered from losses on junk bond positions and the halting of the
lucrative flow of new stock market flotations.

Yet it would seem prudent to declare an end to the long global bull
market which has been driven by the extraordinary expansion of the US economy.

Over the five-year period 1995-99, the S&P 500 Index multiplied in
value more than threefold, equivalent to average annual growth of 26 per cent.

The puncturing of the bubble is scarcely surprising. In this space las000000">Txt
Txt
t
new year's day I forecast that bonds would beat equities in 2000, more
particularly in the second six months. So far this year the total dollar return
on the FTSE World Index has been minus 11 per cent, and on the J.P.Morgan
Global Government Bond Index minus 2 per cent. Bonds are ahead, then - if you
have avoided telecoms paper.

Dollar in danger David Hale, FT,
September 5 2000 The writer is chief global economist at Zurich Financial
Services Group

The US dollar has been so resilient for so long that most commentators
cannot conceive of circumstances in which it would experience a sharp
correction. Foreign demand for US assets remains so strong that there is little
reason for investors to lose faith in the short term. But once the US
presidential election is over confidence could be tested by a variety of policy
surprises.

The second great risk posed by the presidential election is that it
could set the stage for a clash between monetary and fiscal policy next year.
The US currently enjoys such a large federal budget surplus that it will be
impossible to prevent fiscal policy becoming more expansionary. The total
surplus is projected to be $4,500bn over the next 10 years, or $2,500bn
excluding Social Security.

In addition to the risk of inflationary overheating, Mr Greenspan is
also concerned at the size of the US current account deficit and the danger
that fiscal stimulus could increase it further. During the late 1990s, the US
private savings rate fell sharply as the government built up large surpluses.
If the government now reduces its surplus without any offsetting change in
private savings, the current account deficit would easily expand to 6-7 per
cent of GDP.

In the 1980s, fiscal stimulus initially helped to bolster the value of
the dollar by increasing real interest rates. But it is unclear if tax cuts and
higher spending would be as positive in 2001-2002 because of the changes which
have occurred in the USs external financial position since the early
Reagan years.

The US will soon have a deficit on its international investment account
of 20 per cent of GDP, compared with a previous peak of 24 per cent in 1894.
The expansion of the current account deficit to 6-7 per cent of GDP when there
is already a deficit on investment income could at some point frighten the
foreign exchange market and set the stage for a dollar correction.

By Philip Coggan, FT, September 5 2000 The bullish case is
that the last six months have sorted out the technology sheep from the goats
and investors are indulging in some sensible bargain-hunting. I simply
cant believe it. Valuations remain at extremes. The price-earnings ratio
on both the telecoms and the software sector is over 80. The markets
top quartile stocks have a rating five times the lowest quartile stocks - that
is down from a peak of 6.5 in March but still well above the early 1990s when
the dispersion never climbed above three.

Holidays can be a useful time for business people to raise their eyes
from the day-to-day grind and take stock of the wider social and economic
context in which they are operating. For this group, the literary holy grail is
that rare book that entertains, stimulates the intellect, and encourages
lateral thinking.

Unfortunately, the biggest business issue of the day - the internet
revolution - has produced remarkably few books which come anywhere near this.
Almost all are breathless, boosterish or adulatory.

Not so The Social Life of Information (Harvard Business School
Press), which looks at the interaction between information technology and human
intelligence and concludes that information is not the same as knowledge; that
it takes human flair and enthusiasm to create wisdom.

A strength of the book is that it is written not by luddites but two men
close to the cutting edge: John Seely Brown is chief scientist at Xerox's Palo
Alto research centre, home of some of computing's biggest breakthroughs, while
Paul Duguid is an academic at the University of California, Berkeley.

Michael Lewis captures some of the flavour of Silicon Valley in The
New New Thing (Hodder & Stoughton), an uneven but entertaining portrait
of Jim Clark, the larger-than-life serial entrepreneur who created the internet
browser company Netscape.

Anyone with severe market withdrawal symptoms should read Irrational
Exuberance (Princeton), a critique of the Wall Street bull market by Robert
Shiller, Yale economics professor, who examines the psychological factors (herd
behaviour, sports-like media coverage and new age thinking) behind the rise of
the Dow and reaches some chilling conclusions.

For a historic perspective, The Go-Go Years by John Brooks
(Wiley) is a classic account of 1960s exuberance (with some eerie parallels to
now) and its spectacular demise. For takeover junkies, Taken for a Ride: How
Daimler-Benz Drove Off With Chrysler by Bill Vlasic and Bradley Stertz
(Wiley), presents a breathless and US-centric but entertaining account of
Daimler's swallowing of Chrysler.

Globalisation is another big business issue, but books on the subject
tend to be dull or platitudinous - not great beach reading. Better to delve
into two works, published a few years ago, that put in sweeping historical
context the factors that have made some countries rich and others poor.

The Wealth and Poverty of Nations by David Landes (Little, Brown)
offers the analysis of an erudite historian. Guns, Germs and Steel by
Jared Diamond (Vintage) presents an extremely original scientist's-eye
perspective. A book to change your view of the world.

For those who prefer their literature classical rather than post-modern,
Anthony Trollope's The Way We Live Now (Oxford) is a tale of a great
financier's fraudulent machinations in the 1870s railway business, and a satire
of a society in the throes of bull market excess. But on second thoughts,
perhaps that is a little close to home.

Is VoiceStream Worth the Price? Herald Tribune, July 25, 2000

The $50.7 billion price for VoiceStream Wireless Corp., a cellular
service provider based near Seattle, set a dizzying record for acquisition
costs in the telecommunications industry, based on price per customer, and left
rivals in awe of the leap in expansion costs.

''Two weeks ago, no one would have believed that anyone could pay
$20,000 per subscriber for any mobile service anywhere in the world,'' said
Fabrice Farigoule, telecommunications analyst in Frankfurt at the B. Metzler
Bank.

Gabriel Stein about the dollarFinancial Times 2000-07-19, by
Daniel Bogler

The greenback's strength reflects inflows of foreign money as
international investors have chased the high real returns generated by assets
in the booming US. As a by-product, a strong dollar has helped to keep a lid on
inflation, financed the country's growing current account deficit and prolonged
the boom.

But this virtuous circle could rapidly turn vicious. According to
Gabriel Stein of Lombard Street Research, another steep rise in foreign
purchases of US equities in the first quarter of this year shows that the US is
building up a "dangerous dependency on 'hot' capital flows" just as the Asian
economics did in the run-up to the 1997 crisis.

Jeff Madrick: Will the Market Crash? The New
York Review of Books, Cover Date: August 10, 2000

The uncertainty of future profits and dividends, it may seem, leaves a
particularly wide margin for error in the evaluation of stock prices. But even
so, many and perhaps most economists believe that stock prices usually reflect
a reasonable estimate of a company's future performance, and that stock prices
deviate from this intrinsic value only temporarily. It is not necessary,
moreover, that most investors be right about stock prices. A relative handful
of well-informed investors will sell or buy stocks if their prices are
irrationally driven too high or too low.

In fact, so "efficiently" do these investors gather and evaluate new
information that it is extremely difficult for one well-informed investor to
have an advantage over others. Rarely, however, have the movements of the stock
market tested the validity of this thesis as they do today. It is hard to
open the financial pages of the newspapers and avoid a discussion about whether
there is speculative "bubble" in stock prices that is about to burst.
[more]

All this comes at a justifiable price, reflecting both PaineWebber's own
admission that it lacks a global presence and the systematic undervaluation of
brokerage stocks on Wall Street. Despite a 47 per cent premium, UBS is paying
just 18 times expected 2000 earnings or around 3.8 times book value.

Morgan Stanley - admittedly a stronger all-round franchise - trades on a
similar earnings multiple and over six times book without a whiff of takeover
speculation. FT Lex 2000-07-13

The probability that real prices on Wall Street will be lower at the end
of 2008 than at the end of 1998 is 85 per cent. This is a startling statement.
Yet if history and economic theory remain guides to the future, it is also
quite correct.

My colleague Philip Coggan has already reviewed the book (FT April 19
2000), but its argument deserves another look. It is too important to ignore.

It is conventional wisdom that it always makes sense to buy and hold
stocks. In the long run, this is true. But, as Keynes said, in the long run we
are all dead. It has not been true for the time horizons relevant to most
investors. The book shows that there were many years in the last century when
it was a very bad idea to buy stocks if one's time horizon was 20 years, or
less.

It is the ratio of the stock market value of companies to their net
worth. Today, q says that it is more than twice as expensive to buy companies
through the stock market than it costs to create them.

Over the long term, the two values have to converge. The question is
how. Will it be through a rise in corporate net worth or through a collapse in
the stock market's valuation?

The answer to date is clear: over the past three-quarters of a century,
the correlation between changes in q and in stock prices is very high.

Those bad years for investors were also years of relatively high q.

Since q has recently been higher than at any point in the previous 100
years, the conclusion is that the market is highly overvalued and likely to
fall.

When an altimeter leads to so unpleasant a conclusion, people react by
thinking it must have become unreliable. The core propositions of those who
reject q's uncomfortable message are two.

The first is that traditional estimates of net worth are no longer
valid.

The second is that the adjustment to the high q will occur not through a
fall in stock prices, but through investment, further stimulated by a lower
cost of capital.

The first is clearly wrong. The second is logically possible, but at
best unlikely.

The most important arguments under the first heading concern so-called
intangible assets. Jan Hatzius of Goldman Sachs makes the argument as follows:

"Unmeasured intangible assets have most likely grown faster than
physical assets... This is because in the process of economic growth,
industries that intensively use intangible capital, such as technology and
entertainment, tend to grow relative to industries that do not, such as basic
manufacturing and services."

But the view that corporate net worth is seriously underestimated for
this reason is implausible, for at least three reasons.

Second, the measured return on capital must include the return on
unrecorded intangible assets. If, as people argue, such assets are a large
fraction of the total, then the measured rate of return on capital should be
higher than ever before. The rate of return on corporate capital did achieve a
good cyclical rise in the 1990s. But it remains well below the level it
achieved in the 1960s.

Finally, these moderate actual returns on corporate capital are also
inconsistent with the one good reason why corporate assets may be more valuable
today than before - a rise in monopoly. In any case, for every new alleged
monopolist, such as Microsoft or Intel, one can mention weakened old ones, such
as AT&T and IBM.

Thus the belief that the staggering rise in q can be explained by the
growth in unrecorded assets is nonsense.

Mr Hatzius accepts this, noting that unmeasured intangible assets would
have had to increase by $12,500bn since 1990. There is no reason to believe any
such thing.

If the rise in q cannot be estimated away, the second line of attack is
to argue that it is perfectly reasonable. Here two points are made.

One is that it reflects improved prospects for productivity.

Another is that there has been a fall in the equity risk premium.

Again, neither of these explains q's rise convincingly.

There is no obvious reason why higher prospective productivity growth
should raise the value of existing assets, even if it is true. Accelerated
technical change is as likely to reduce the value of such assets. Moreover,
rational investors should expect returns from higher efficiency to be bid away
by competition in favour of workers and consumers. Indeed, if the required
return on equity investment has been reduced by a falling risk premium, as many
argue, this gain will be more than bid away.

This leaves the last possibility - that adjustments to q will occur not
through a fall in equity prices, but via an expansion in corporate net worth. A
fall in the equity risk premium (and so of the corporate cost of capital) could
then help explain both the increase in stock market value and the subsequent
surge in investment.

This is conceivable, but implausible, not least because there is little
good reason to believe that the equity risk premium has fallen.

But two additional points can be made.

First, it could take a half century for investment alone to bring q back
towards its historic average. The slow pace at which the capital stock grows
explains why adjustments to q have, in the past, occurred through the price of
stocks instead.

Second, people are not behaving as though the prospective real return on
equity is lower than for any extended period in the past two centuries. In
surveys, investors still talk of the exceptionally high returns enjoyed since
the early 1980s. Meanwhile, far from financing themselves with the supposedly
cheap equity, companies are doing the reverse.

In recent years, US corporations have been enormous net buyers of
equity. This hardly suggests they believe equity finance is unusually cheap.

Try as one might, the q ratio's recent levels remain disturbing. It is a
theoretically and empirically sound indicator of market value. It is also
extraordinarily high.

Nobody has given a compelling explanation for this, other than the
obvious one.

The only sensible alternative is that the desired return on equity is
now far lower than ever before. Yet this looks like a fairy story, if one
without a happy ending.

In the past, collapses in q have meant falls in stock prices that have
heralded recessions. Will this story end any differently?

From The euro fights back by Barry Riley, FT, June 9, 2000

There are worriers around. This week, the Bank for International
Settlements, the central bankers' central bank, emerged from its usual
obscurity in Basle to publish its annual report. "The global economy now stands
on the brink," it announced. "But," it added unhelpfully, "the brink of what?"
The danger of a nasty global rebalancing, focused on a tumble by the US dollar,
seems to underlie its anxieties.

Central bankers and journalists are habitual gloomsters. People have to
rely on stockbrokers and the promoters of mutual funds to spread sunshine.

Pessimism has begun to lift: as the leading economies slow down ahead of
a soft landing, the threat of sharply higher interest rates is fading and we
should be able to concentrate on the wonderful story of technology-led change
and inflation-free growth. Think of the US investors who have made so much
money by buying the dips over the past five years.

But central bankers and journalists don't easily believe in miracles.
Unconstrained optimism has regularly proved costly in the past. The Japanese
miracle, which at one time terrified corporate America, fizzled out in 1989.
The Asian miracle had a good run but eventually crashed in 1997. As for the UK,
the Lawson miracle encapsulated the usual features of booming growth, rocketing
asset prices and a yawning but (for a while, at least) easily-financed trade
gap. Yet, it hit the buffers in 1988.

It is the huge imbalances that catch the eye at present, such as a US
current account deficit heading towards $400bn a year.

However, the investment flows may be just as important. Indeed, there is
something of a chicken-and-egg problem here. Do the investment flows happen
because countries find they are piling up excess dollars through trade? Or do
the trade gaps widen because institutions or companies around the world are so
keen to invest in the US that they are driving the dollar to uncompetitive
levels?

Either version of events suggests unsustainability, though the second
might well prove longer-lasting.

In an old-fashioned, divided world economy, the rebalancing pressures
would be high. In those circumstances the US, Japan and the euro-zone should be
more or less financially self-contained. But, in a globalised economy, they
need not be.

If Japan wa
nts to sustain a high personal savings rate but Americans
spend their way towards a negative one, that will be possible for an extended
period. However, the Japanese must be ready to invest overseas and the
Americans must accept the responsibilities and drawbacks of being the world's
biggest debtors; the costs are much greater than just those of reassuring
foreign hoarders of greenbacks that their wealth is not threatened by the
redesign of the notes, a problem the US is now having to address.

As for the euro-zone, the ECB seems determined to consolidate the
recovery by the euro against the dollar of 7 per cent since the low point on
May 17. It has been the sharpest rally during the whole period of downwards
drift (aggregating 25 per cent at its worst) since the new currency was born 17
months ago.

The ECB might have realised that its low interest rate strategy could
have encouraged so-called "euro-carry" trades (the borrowing of euro to be
switched into higher-yielding dollar assets). This is a rather pale version of
the Japanese yen-carry trade which was very substantial during the late 1990s,
driven by much wider interest rate differences. But that game ended last year
when several New York hedge funds lost money.

Carry trade distortions can generate persistent exchange rate trends,
but can also cause sudden sharp reversals when the risks of the currency
mismatching become painfully obvious and positions are unwound abruptly.

As the BIS describes in its annual report, much of the euro's slide can
be linked to the rapid development last year of euro-denominated financing,
encouraged by low interest rates, and the widening perception by borrowers that
the euro would prove to be a persistently weak currency. The ECB has repeatedly
refused to evade this psychological trap by directly intervening to support the
euro but, instead, it has now moved quite aggressively on interest rates.

The potential fundamental problems of Japan are considerably greater.
Japanese citizens are big savers, which is unfortunate in a country short of
demand; but, so long as they are content to stash the money away in (almost)
zero interest rate accounts, the system will remain stable. The trouble is, the
financial ratios will grow ever more frightening.

Rather similarly, the US financial system will remain stable as long as
foreigners are happy to channel $25bn a month into dollar securities or
corporate investments.

But it is easy to understand why all this is viewed nervously in Basle.

True, the brink is defined by my dictionary as the edge of a steep
slope, with some ambiguity about whether the gradient is upwards or downwards.
Perhaps the rest of the world is about to share in the economic acceleration
already enjoyed by the US.

Normally, though, brinkmanship involves tactics leading to the edge of
disaster.

On a trade-weighted basis, the dollar has suddenly dipped by 5 per cent,
eroding some of the protection that currency strength has given the US against
imported inflation.

Higher interest rates are required to hold back demand and inflation -
but lower rates are needed to support the US securities markets and keep
foreign investors happy.

Ghosts of Booms Past By Robert J. Samuelson
Washington Post, February 8, 2001

It may be a sign of the times that a 10th-grade history teacher recently
assigned the following essay topic: What caused the Great Depression, and how
do economic conditions then (the 1920s) and now compare?

The parallels between the 1920s and today are intriguing and (of
course) unnerving, because the Depression was -- after the Civil War --
America's greatest social calamity. In 1933 joblessness hit a record 25 percent
of the labor force. Indeed, unemployment remained in double digits from 1931
until 1940, when it was cured by World War II defense spending.

The Great Depression was terrifying because it was so resilient. Hardly
anyone thinks it could happen again.

Nobody can have made much money out of betting against Alan Greenspan.
But the US Federal Reserves redoubtable chairman is engaged in perhaps
his trickiest task: slowing the US supertanker while avoiding the recessionary
shoals. Most people confidently expect him to pull it off. Yet the likelihood
of failure is considerable.

According to the latest Economic Outlook from the Organisation
for Economic Co-operation and Development, real US domestic demand grew at an
average annual rate of 5.3 per cent a year between 1997 and 2000. Over the same
period, the growth of real gross domestic product averaged 4.6 per
cent.Since even this impressive expansion lagged behind demand, the result
has been a sustained rise in the current account deficit, up from just 1.6 per
cent of GDP in 1996 to a forecast of 4.3 per cent this year.

Even though the OECD has raised its view of the potential growth rate of
the economy to 4 per cent a year, it estimates the current output gap - the
deviation of actual GDP from potential GDP, as a percentage of the latter - at
2.5 per cent.

Thus excess demand has shown itself in both the current account deficit
and unsustainable exploitation of domestic resources.

Against this background, the slowdown in the third quarter, with growth
falling to an annualised rate of 2.4 per cent, is exactly what Mr Greenspan
ordered. The big risk he runs is that the impact of this slowdown on confidence
will trigger a rapid unwinding of todays huge private sector financial
deficit - or excess of investment over savings. This has happened to a number
of other high-income economies over the past 20 years. The universal result has
been recession.

I discussed this vulnerability in a recent article for Foreign Policy.
The Mother of all Meltdowns: what a Wall Street Crash will do to the
world, Foreign Policy, September/October 2000 www.foreignpolicy.com.

Between 1992 and 2000, the US private sector moved from a financial
surplus of 5 per cent of GDP, about 2 percentage points above its 1986-93
average of 2.7 per cent, to a historically unprecedented deficit of just over 5
per cent. This swing of 10 per cent of GDP in the US private sector financial
balance has, in turn, been the principal engine of demand for the US economy
and, to a significant extent, for the world.

Behind the swing in the US private sectors financial balance have
been both rises in the share of private investment and declines in the share of
private savings in GDP. In 2000, private sector investment should reach 18.5
per cent of GDP, according to the International Monetary Fund, up 3.3
percentage points from its 1986-93 average. Meanwhile, private sector savings
in 2000 should be about 13.4 per cent of GDP, well down from the 1986-93
average level of 17.9 per cent.

Why should US private investment have been so buoyant and private
savings so weak? The answer is confidence, as shown in - and reinforced by -
the soaring value of equities. Between August 1994 and August 2000, the real
wealth (in 2000 prices) embodied in the stock market rose by $11,400bn - more
than a years GDP.

The impact of this enormous increase in paper wealth on savings is
difficult to determine. But it must have been substantial. Why should people
bother to save as much as before when the stock market painlessly delivered,
over a period of just six years, an increase in wealth greater than cumulative
gross savings (never mind net savings) over such a period? But rising stock
market valuations not only give a good reason to reduce savings. They have also
stimulated investment.

The swing of the US private sector into financial deficit is a
reflection of a virtuous circle: limited inflationary pressure; rising
profitability and accelerating productivity growth; optimism among consumers
and investors; soaring equity values; an improving fiscal position; powerful
foreign demand for US assets; a strong dollar; and back again to limited
inflationary pressure.

The question now is whether the recent collapse in the value of
technology stocks, combined with slowing economic growth, could turn that
virtuous circle into a vicious one.

In other high-income countries afflicted by significant declines in
asset prices, swings in the net financial balances of the private sector have
been as much as 10 per cent of GDP within a few years. That would bring US
private sector financial balances back to where they were in 1992.

Such a reversal could follow a big collapse in confidence. That, in
turn, would be reflected in - and multiplied by - a further big fall in equity
prices. Since the market, excluding technology, media and telecommunications
stocks, continues to trade at historically high price-earnings ratios - even
though earnings are at cyclical peaks and the economy is slowing - the risks of
this cannot be negligible.

Optimists insist that the tools of fiscal and monetary policy, combined
with adjustment to the external balance, could offset the impact on economic
growth of even drastic private-sector retrenchment. Formally, that is correct.
But Japanese and British experience suggest that this can be difficult to
achieve.

In the UK, for example, the general governments financial balance
collapsed from a surplus of just under 1 per cent of GDP in 1989 to a deficit
of 8 per cent of GDP only four years later. According to the OECD, five
percentage points of this deterioration reflected deliberately expansionary
fiscal policy. Even so, the economy contracted sharply. Similarly, Japans
general government financial balance moved from a surplus of just under 3 per
cent of GDP in 1990 and 1991 to a deficit of 7 per cent last year. More than 8
percentage points of this deterioration reflected deliberate easing. Yet Japan
has suffered a decade of stagnation.

It is implausible that US fiscal policy would, or could, be used with
enough aggression to offset more than a modest swing in the private
sectors net financial balance, although a President George W. Bush might
give it a good try. The so-called built-in fiscal stabilisers - the decline in
tax revenues and increases in spending that automatically follow recessions -
would merely cushion the impact, although at the price of a return to big
fiscal deficits.

Monetary policy might be still more ineffective. In the context of a
stock market collapse, the household sector would want to rebuild its wealth,
not take on more debt. The corporate sectors willingness to invest would
be curtailed by declining equity valuations and slowing economic growth.

The immediate impact of an aggressive loosening of monetary policy would
probably be on the exchange rate and the external account. Yet difficulties
could then arise.

The Federal Reserve might be constrained by fear of a very weak dollar.
In 1999, a current account deficit of $339bn was more than financed by $228bn
in net foreign private sector purchases of US non-government securities and
$130bn in net inflows of foreign direct investment.

If this inflow turned into an outflow, the US would have to finance both
that outflow and the current account deficit. This could be done only with huge
inflows of short-term speculative capital or purchases of dollars by foreign
governments and central banks. Moreover, to the extent that the US is able to
offset recession by improving its external balance, it will be exporting its
problems to the rest of the world.

The US must now move smoothly to slower growth of demand and output
without shaking underlying confidence. If this is to happen, the US private
sector must remain both able and willing to run its unprecedented financial
deficit. Possible? Yes. Certain? Hardly, is the only possible answer.

Spare a thought for the poor beleaguered central banking community.
Yes, theyre in nice, safe public sector jobs. But their reputations are
starting to fade.

Philip Coggan, FT, August 27 2000

Not long ago, confidence in central bankers was astonishingly high. They
were the men (there is the occasional woman, but the profession appears to have
a marble ceiling problem) who had worked out how to control inflation. Alan
Greenspan, in particular, could walk on water.

The surge in the price of oil has clearly compounded the dilemma. One
response would be to ignore this development. Core inflation remains subdued.
The oil price is much less significant to the global economy than it was in the
1970s. To the extent that higher oil prices do have an effect, it will be to
dampen demand, as wealth is transferred from consumers in the US, Europe and
Japan to producers in the middle east and Latin America.

The problem with ignoring the oil price rise is that it will hand a
smoking gun to the central banks critics. At this stage of the economic
cycle, when no-one is quite sure whether the world economy is on the verge of a
new era or an inflationary boom, central banks are very vulnerable to the
wasnt it obvious? attack.

Wasnt it obvious, they will say, that high oil prices, high
stock markets, the weak euro, the US current account deficit, rising debt
levels (take your pick) would lead to disaster?

Survey Puts Analysts Into Two Camps Over Fed's Ability to Curb
Inflation

By CONSTANCE MITCHELL FORD

Staff Reporter of THE WALL STREET JOURNAL

July 3, 2000

NEW YORK -- Economists are confident that the Federal Reserve will
engineer a soft landing this year for the U.S. economy, where growth continues
to expand but at a slower, more sustainable pace.

However, economists are deeply divided over whether the soft landing
will succeed in keeping inflation under wraps.

The consensus estimates of the 55 economists who participated in The
Wall Street Journal's latest semiannual forecasting survey call for annualized
growth in inflation-adjusted gross domestic product of 3.6% in the second
quarter, 3.4% in the third quarter and 3.2% in the fourth.

Those forecasts indicate that analysts believe the economy has already
begun to slow from the red-hot pace of recent quarters and will continue to
slow throughout the year. GDP grew at an annual rate of 5.5% in the first
quarter of this year and a blistering 7.3% in the fourth quarter of last year.

Essentially, the forecasters appear to fall into two major camps: the
optimists and the pessimists. The optimists believe that the Fed, which has
been raising interest rates for the past year in an effort to steer the economy
toward a 3.5% to 4% annual growth rate, will pull off the perfect soft landing
by slowing growth just enough to cut off inflationary pressures while keeping
unemployment stable.

"I'm betting on the Fed," said economist Nicholas Perna, of Perna
Associates in Boston. Federal Reserve Chairman Alan Greenspan "is the master of
the soft landing, having successfully slowed the economy through higher
interest rates without causing a recession in 1994-95 and even in 1987-88."

The pessimists also believe that the Fed will engineer a soft landing --
at least in the near term -- but they worry that the Fed's actions haven't been
aggressive enough to contain inflationary pressures. And they see evidence of
accelerating inflation in the tight labor market, in rising commodity prices
and in the huge and growing current-account deficit.

A few even worry that when it becomes obvious later this year that the
Fed wasn't vigilant enough in its inflation fight that interest rates will have
to rise further, raising the possibility that growth could falter and the
economy could slip into a recession next year.

"I think we all recognize that there are various imbalances that must be
worked out," says Robert DiClemente, chief U.S. economist at Salomon Smith
Barney in New York. "The key between the two camps is do we or don't we get
into a tough inflation fight."

OECD Economic Outlook, No. 6, 2000:

The United States economy has now recorded its longest
upswing this century and it continues to be spurred by strong consumer demand,
business capital formation and, increasingly, exports as the global recovery
gains momentum. However, the recent strength of domestic demand is not
sustainable and inflationary pressures are now becoming apparent, while the
current account deficit has risen sharply, to above 4 per cent of GDP. The
challenge for the authorities is to achieve an orderly reduction in demand
growth to prevent overheating and avoid the need for a much sharper subsequent
tightening of policy. The task facing the monetary authorities has been made
more difficult, however, by the strength of financial markets and is
complicated by the uncertainty about the extent to which new technology and
structural change have raised the economys non-inflationary potential.
Notwithstanding significant improvements in trend productivity, the monetary
tightening that has already taken place is unlikely to restrain demand growth
sufficiently. Hence a further tightening of monetary policy is called for and
federal funds rates may have to rise to above 7 per cent by next August to
ensure a soft landing.

The Need to Fear a Hard Landing By John H. Makin, American
Enterprise Institute, June 2000

Financial markets are pricing a soft landing for the U.S. economy as
the Federal Reserve raises interest rates to slow demand growth and the rise of
inflation. Simultaneously, the economic data appearing this spring contain the
seeds of a hard landing. The resolution of this disconnect between market hopes
and economic reality will produce a continuation of the extraordinary
volatility in equity markets and a spread of volatility to fixed-income,
commodity, and currency markets. Strange as it may seem, markets need to fear a
hard landing before they can settle down.

Right now, market insouciance notwithstanding, the outcome in the
contest between a hard and a soft landing is too close to call. But it is time
to start thinking seriously about ways to tell the difference between the two.

A soft landing would mean that about 50 basis points more of Fed
tightening, putting the Fed funds rate up to 7 percent, in addition to the May
16 Fed rate increase of 50 basis points, would slow the economy down to 3.5
percent growthquickly enough to avoid much more than the 3.7 percent
year-over-year headline inflation already evident this spring, not to mention
the 4.3 percent wage inflation reported recently in the quarterly Employment
Cost Index.

In a soft landing, the dollar wont fall much and stocks wont
fall much more.

The catch is that such benign conditions wont do much to slow U.S.
demand growth.

In a hard landing, not seen since 1979-1980, inflation is stubborn,
continuing to rise as the economy powers ahead or, worse, refusing to fall even
as growth begins to slow. Inflation has momentum, and it doesnt stop
rising even as the Fed keeps raising interest rates. During the prelude to a
hard landing, the Fed raises interest rates, but inflation goes up even more so
that the real cost of borrowing keeps falling and households and businesses
arent deterred from spending.

Modern economics makes itself intelligible by adopting everyday
analogies. If inflation worsens, we say the economy is "overheating." If the
Federal Reserve raises interest rates, it's "applying the brakes." If it cuts
rates, it's "stepping on the gas." The metaphor of the moment is "soft
landing." The economy slows enough to avoid higher inflation but not so much
that it suffers a "hard landing" (a recession). It's an enticing vision--which
may or may not come true.

The trouble with these analogies is that, even as they clarify, they
oversimplify. The case for a "soft landing," though plausible, may not come
true because the economy is not an airplane and Alan Greenspan - chairman of
the Federal Reserve Board - is not its pilot.

The main difference involves control. Pilots have a lot of it. Landings
and takeoffs are routine. By contrast, the Federal Reserve tries to steer the
nearly $10 trillion U.S. economy through one tiny instrument: the obscure Fed
funds rate. This is the interest rate on overnight loans between banks. When
the Fed funds rate moves, the ripple effects spread to other short-term rates
(on home-equity loans, business loans), long-term rates (on mortgages, bonds),
exchange rates, the stock market and popular psychology. But the connections
aren't always the same or entirely predictable.

To shift analogies: the Fed has a small lever (the Fed funds rate) to
move an immense boulder (the economy).

Confidence in the "soft landing" stems from the current boom -which has
consistently defied pessimists - and a fervent faith in Greenspan. His record
surely warrants respect.

The economic expansion, now in its 10th year and the longest in U.S.
history, has already experienced one "soft landing." Between February 1994 and
February 1995, the Fed funds rate went from 3 percent to 6 percent. Some
economists feared a recession. It never came.

Greenspan prides himself on acting preemptively: judging economic
conditions and altering rates to prevent major problems. After Asia's financial
crisis in 1997 and 1998, the Fed cut rates. Beginning in June 1999, it started
raising them again on the theory that the boom - if unrestrained - would create
inflationary wage and price pressures.

Sure enough, these seemed to appear in early 2000. Through May the
consumer price index has risen at an annual rate of 3.6 percent compared with a
2.7 percent rise for all of 1999. The employment cost index - a measure of
labor compensation -increased 4.3 percent for the 12 months ending in March. A
year earlier, the gain was only 3 percent.

But right on schedule, it seems, the slowdown arrived:

Retail sales- everything from food to cars - dropped in April (0.6
percent) and May (0.3 percent).

In May the unemployment rate inched up to 4.1 percent from 3.9 percent,
and private-sector jobs declined by 116,000.

Housing construction has weakened, with new-home starts in May--at an
annual rate--10 percent lower than in December.

"Consumers have been on such a spending binge that while they say it's
a good time to buy a car or house, they've already bought a car or house," says
economist Cynthia Latta of Standard & Poor's DRI. "And if you're not
building as many new homes, you don't need as many new appliances."

The economy seems to be landing softly. But could this picture be
wrong? Well, yes.

For starters, the slowdown may be a mirage- a "temporary payback" for
the rapid growth of late 1999 and early 2000, says economist Ira Kaminow of the
Capital Insights Group. In the last three months of 1999 the economy grew at an
astounding annual rate of 7.3 percent. People may have bought in December what
they would have bought in May.

Once this effect wears off, the economy may resume growing at more than
4 percent--faster than the Fed wants--and require further interest-rate
increases. (Since mid-1999 the Fed has raised the Fed funds rate from 4.75
percent to 6.5 percent. It will consider interest rates at a meeting next
Tuesday and Wednesday.)

Or the slowdown may prove worse than expected. "Lower-income household
debt is very high," says Mark Zandi of Regional Financial Associates. "That may
be the economy's Achilles' heel."

Even in 1998, about a fifth of households with incomes of less than
$50,000 needed 40 percent or more of their after-tax income to pay interest and
principal on debt, he reports. Higher gasoline prices are another possible
problem. They could depress consumer confidence and spending, says Susan Sterne
of Economic Analysis Associates. Jobs, profits, the stock market and corporate
investment could suffer.

None of these economists yet predicts a recession. In the Standard
& Poor's DRI outlook, the economy grows nearly 5 percent in 2000 and slows
to 3 percent in 2001. Unemployment hovers around 4 percent. As slowdowns go,
that's spectacularly benign. On the other hand, forecasters have often missed
major economic turning points.

Everyone is dealing in educated hunches. The imagery of a "soft
landing" promotes a false sense of mastery. Pilots know how far and fast their
planes can fly. With radar, they have a good sense of weather and terrain. Our
economic vision is more clouded. Statistics and studies give incomplete or
conflicting answers about current conditions (say, inflation) and the economy's
potential growth rate.

The larger point is that the economy responds to its own rhythms: new
technologies, products, popular moods, management practices, government
policies. The Fed is only one influence, although an important one.

In the 1960s and 1970s, the metaphor of choice was "fine tuning."

Government could sustain "full employment," it was said, by tweaking
various policy dials--taxes, spending, interest rates. The effort failed
notably. This history is worth recalling, because it suggests that today's
hyperconfidence could usefully be accompanied by some humility.

George Soros: markets must be regulated Speaking to BBC News Online, Mr
Soros said that markets would continue to view the single currency as a
"one-way bet," which could easily tumble to below $0.80 and even risked
"disintegration" as a currency.

Mr Soros warned that the world's next financial crisis was likely to
originate in the relationships among the world's biggest countries, not in the
"periphery" as during the Asian crisis of 1997.

In particular, he was worried about the growing imbalances in the US
economy.

He warned that the US was running an unsustainable current account
deficit, and that the dollar could come under pressure in the event of a stock
market crash.

And he said that the consequences of a "hard landing" where the US was
forced to raise interest rates to defend the dollar, would be severe for the
rest of the world.

Mr Soros spoke to the BBC at the sidelines of a conference on reforming
the global economic architecture sponsored by the Centre for Economic Policy
Reserch and the UK's Economic and Social Research Council.

Growing too fast for comfort A rapid
rise in productivity has raised the US growth rate but brought with it an
unsustainable level of demand Martin Wolf, FT, 4 Apr 2000

Something remarkable is happening in the US economy. Yet while
everyone agrees on this, people disagree on what that something is. To some it
is a bright "new economy". To others it is the bubble to end all bubbles.

Yet these views are not as opposed as they may seem to be. It is
perfectly possible for genuine improvements in underlying economic performance
to generate a destabilising asset-price driven surge in demand. It is not only
possible, but probable, as Alan Greenspan has been stressing.

The chairman of the Federal Reserve explained how he sees underlying US
performance as follows, in a speech delivered on March 6. "In the last few
years, it has become increasingly clear that this business cycle differs in a
very profound way from the many other cycles that have characterised
post-second world war America. Not only has the expansion achieved record
length, but it has done so with economic growth far stronger than expected.
Most remarkably, inflation has remained largely subdued. A key factor behind
this extremely favourable performance has been the resurgence in productivity
growth."

For close to a quarter of a century, economists have struggled to
understand the phenomenon described by Robert Solow, the Nobel laureate from
the Massachusetts Institute of Technology, who asserted that "you can see the
computer age everywhere but in the productivity statistics".

Now it can even be seen there. An unpublished paper by Stephen Oliner
and Daniel Sichel, economists at the Federal Reserve in Washington DC,
concludes that "the use of information technology and the production of
computers accounted for about two-thirds of the one percentage point step-up in
productivity growth between the first and second halves of the 1990s".*

Their analysis uses a standard growth-accounting framework, in which
increases in labour productivity reflect a rising ratio of capital to labour
and overall technical progress, which is known as "multi-factor productivity"
(MFP). The annual growth of labour productivity in the non-farm business
sector, they argue, jumped from 1.61 per cent between 1991 and 1995 to 2.67 per
cent between 1996 and 1999. Almost half of this increase (0.46 percentage
points of the total rise of 1.06 percentage points) is due to increased
availability of information technology; and roughly a third (0.35 percentage
points) is due to technical progress in the production of computers and
semiconductors.

Why has it taken so long for this technological revolution to show up in
the productivity numbers? Jeremy Greenwood of the University of Rochester, New
York argues that this should be no surprise. This is exactly what happened
during the first and second industrial revolutions in the UK in the late 18th
century and the US in the late 19th century.** Then too, the initial impact was
an apparent reduction in productivity growth, as costs were incurred in
understanding and developing the new technologies. Then too, there was an
increase in inequality caused by the scarcity of people competent with the new
technologies.

This phenomenon of slow adaptation and diffusion would help explain the
second striking feature of today's changes: the absence of any improvement in
productivity growth outside the leading country. Labour productivity in Japan,
Germany and the UK is forecast by Goldman Sachs to grow even more slowly
between 1995 and 2000 than between 1977 and 1995 (see chart). It is expected to
grow only marginally faster in France. But, as before, the opportunity to catch
up remains open to the laggards, provided they make the necessary adaptations
to policy and business behaviour.

Yet before accepting that the jump in US productivity growth is both big
and durable, it is useful to go back to the work of Robert Gordon of
Northwestern University cited in my column on the new economy of August 4,
1999. Prof Gordon concluded that the underlying improvement in productivity
growth between the two halves of the 1990s was only 0.3 percentage points, all
of which was explained by accelerating productivity rises in computer
manufacturing.

According to Mr Oliner and Mr Sichel, new data available to the end of
1999 raise the increase in underlying productivity growth to 0.6 percentage
points. The chief reason for the remaining difference between Professor Gordon
and the Federal Reserve paper is that the former ascribes much of the recent
productivity rise to the cyclical surge in growth. The authors of the Federal
Reserve paper omit the cycle on the grounds "that separating cycle from trend
is difficult, particularly in the midst of an expansion".

This is true enough. But it also ignores a possibly crucial distortion.
From 1996 to 1999, the US economy grew at an annual average rate of 4.1 per
cent. Over the same period, real domestic demand rose at an astonishing annual
average rate of 5.3 per cent. Making this unsustainable combination possible
were the twin safety valves of falling unemployment and a growing current
account deficit: the unemployment rate fell by 11/2 percentage points from the
end of 1995, while the deficit grew by more than 2 per cent of GDP between 1995
and 1999.

Mr Greenspan ascribes this disturbing surge in demand to the
productivity improvement. In his March 6 speech, he argued that "the pick-up in
productivity tends to create even greater increases in aggregate demand than in
potential aggregate supply" - the transmission mechanism being rising asset
prices. The chart, taken from a new book by Robert Shiller of Yale University,
demonstrates that the market values corporate earnings more highly than at any
time since 1880.*** And, notes the Fed chairman: "The evidence suggests that
perhaps three to four cents out of every additional dollar of stock market
wealth eventually is reflected in increased consumer purchases."

The resulting unsustainable surge in demand does not only affect
monetary policy. It must also qualify any assessment of productivity growth.
Since 1995, productivity has grown even faster than before the sudden growth
collapse that followed the first oil shock, in 1973. But how durably it has
risen cannot be known until the unsustainable demand it has helped cause is
back under control.

* The Resurgence of Growth in the Late 1990s: is Information
Technology the Story? March, 2000.

First a Japan Bubble, Now an America BubbleInternational
Herald Tribunde, April 3, 2000 By Sebastian Mallaby The
Washington Post

- Back in the 1980s, when Japan's economy was riding high, foreign
correspondents had a wonderful time deriding its excesses. Grandmothers were
trading market tips in tea salons. Young women seemed permanently affixed to
French designer handbags. Salarymen toiled night and day, then recovered by
inhaling condensed oxygen and consuming gold leaf with their sushi.

Finally Japan's bubble burst, and in retrospect the meaning of these
signs was clear. A society that had taken to swallowing gold leaf was bound to
be swallowing its pride soon after.

Well, a decade later, oxygen bars have arrived in New York and
Hollywood. And Uncle Sam's Casino in Cripple Creek, Colorado, offers oxygen
hits in eight delicious flavors, peppermint and tangerine among them. Americans
are not eating gold leaf, but some are wearing suits with gold woven into the
pinstripes. For those without $14,000 to spare, ties with 18-karat gold thread
can be had for a mere $260

Or consider household pets in bubble-era America. The Kennel Club in Los
Angeles offers its canine guests theme-decorated cottages complete with TV and
VCR, not to mention workouts to balance the chicken teriyaki on the menu.

Japan's firms drove the salarymen like slaves, then made it up to them
with weekend retreats, golf club memberships and other attempts to secure
loyalty. Now the corporate campuses of America's computer firms offer
everything from exercise to entertainment. Texas Instruments is even willing to
arrange a mechanic to repair an employee's vehicle.

In the four years leading up to the end of 1989, Tokyo's stock market
index rose by an average of 29 percent a year. From 1995 to 1999, the S&P
500 grew at an annual rate of 26 percent.

Western analysts blanched when Nippon Telegraph and Telephone shares
were floated on the Tokyo stock market in 1987 at a price-earnings ratio of
250. After Palm Pilot floated recently, its share price quickly rose to more
than 1,000 times earnings.

Japan was said to be conjuring unprecedented efficiencies from keiretsu,
or networks of firms. Americans are wild about networking, too. John Doerr,
Silicon Valley's venture capital king, has the nerve to use the Japanese term:
His Web site boasts that he has created America's very own keiretsu.

Japan's stock market boom produced corruption in grand style. America's
boom may be creating something of a dot-con economy. In a climate that values
born-yesterday firms at many times their revenues, the temptation to pump up
those revenues is often overwhelming - Web firms advertising with each other
and reporting the ad ''sales'' as income, or counting as income the sale of
goods produced by someone else, even though the Web firm is only getting a
commission.

As in Japan, the party will eventually go sour. But the Japanese
comparison suggests that the hangover will not be as great. Japan had a double
bubble, in the stock market and also in real estate, whereas American property
prices are out of control only in the frothiest patches of the New Economy.

In Japan, moreover, the financial authorities actually contributed to
the bubble. They encouraged investors to think that they would support the
market if it crashed. They connived at accounting tricks that fueled the
speculative frenzy. In America, Alan Greenspan's misgivings about giddy stocks
are widely publicized, and the Securities and Exchange Commission is getting
ready to clamp down on virtual accounting.

Japan's bust proved especially damaging because of the structure of the
country's financial system. Banks owned piles of shares, so the crash wiped out
much of their capital. They lent against the security of shares and property,
so the crash eliminated the banks' ability to recover loans. As a result, the
banks were left too weak to lend. The resulting credit drought lies behind
Japan's decade-long recession.

In America, banks are less exposed to the bubble. They are not major
owners of stock, and they tend not to rely on shares as collateral. They are
not, in any case, as important as banks are in Japan. American companies rely
less on loans than on venture capital and equity financing.

If the stock market crashes in America, the pain will be distributed via
mutual funds and day-trading accounts to millions of shareholders. It will
trigger personal bankruptcies, mortgage defaults and an end to the consumption
boom. But it will not create the prolonged malaise that comes when you cripple
the financial system.

End of the Boom? Robert J. SamuelsonWashington Post,
March 28, 2000

We may have gotten a small foretaste last week of the endgame of the
Internet investment boom. The hallmark of any boom is unbridled confidence,
which conceals and condones practices that--in a less giddy climate--would seem
sloppy, unethical or illegal. The Internet has been so profitable for so many
that people instinctively confuse economic success with moral infallibility.
This can't last forever, if only because human nature isn't perfect--even the
human nature of the people behind the Internet and computer booms.

What happened last week provided a cautionary tale. Early Monday,
MicroStrategy--a prominent software company--announced that it was revising its
1999 financial results. Sales would drop roughly 25 percent from $205 million
to about $150 million. Profits would change from a reported 15 cents a share to
a loss of between 43 cents and 51 cents. The reaction was swift. On Monday,
MicroStrategy's stock plunged 62 percent, from $226.75 to $86.75.

Bombarded by shareholder suits, MicroStrategy will have ample
opportunity to explain its actions. No one can yet say whether it committed
fraud--or was the victim of overly conservative accounting rules. "I don't
think we made a mistake," says MicroStrategy chairman Michael Saylor. "The
technology has outstripped accounting guidelines." He says the company merely
booked revenues it had in hand and that auditors insisted be spread over the
life of software contracts. However the episode ends, it suggests that the
high-tech frenzy has created an ethical quagmire.

There are huge pressures to project optimism--and prop up stock prices.
The line between what people genuinely believe and what serves their economic
interests has blurred. Perhaps some people can no longer see the line.
Stretching accounting rules (if that is what MicroStrategy did) is a flagrant
trespass. But others are more subtle, ambiguous and, possibly, pervasive.
Questions abound about underwriting practices, the independence of stock
"research," and the use of stock options.

Consider IPOs. These are the "initial public offerings" of stocks by
private companies selling their shares to general investors. The business is
hugely profitable for the underwriters--the brokerage houses that handle the
sales. According to Jay Ritter, a professor of finance at the University of
Florida, the underwriters typically get about 7 percent.

Now, suppose that Whoopee!.com has a $100 million IPO. Why would anyone
buy Whoopee!.com? Well, it helps if the Wall Street underwriter has a popular
stock analyst whose recommendation will push up the price. The best-known
Internet analyst is Mary Meeker of Morgan Stanley Dean Witter. In 1999, she
reportedly made about $15 million. (The figure, cited by the Wall Street
Journal, isn't denied by the firm.) She was paid so much in part because she
helped attract so much underwriting. In 1999 Morgan ranked second in IPO
underwritings at almost $14 billion, just behind Goldman Sachs ($14.5 billion),
reports Thomson Financial Securities Data.

"The conflicts of interest are immense," argues Ritter. Stock analysts
are increasingly "cheerleaders," he says. Their pay depends on the firm's
underwriting, which depends on enthusiastic research reports. Glum Internet
analysts aren't wanted. (Morgan Stanley Dean Witter has a different view:
Meeker does prescreen Internet companies that the firm underwrites; but this
review helps eliminate weaker candidates. "There are lots of companies that
would like to be underwritten by Morgan Stanley Dean Witter," says a
spokesman.)

Capitalism is about risk and reward. If there's risk, some people will
lose. Companies fail. Business plans flop. The dot-com phenomenon won't (and
shouldn't) be any different. That is not the issue. But to work, capitalism
requires reasonably reliable information. If it's skewed, then the risk-reward
equation becomes skewed.

Logic suggests that IPO underwriting standards have eroded--and they
have. Before Netscape's IPO in 1996, companies going public generally were
profitable, says finance professor Jeremy Siegel of the University of
Pennsylvania. Now, most run losses. One reason is that they're younger. In
1995, the average IPO firm was 8.1 years old. By 1999, it was 5.2 years.

Of course, this is a godsend for venture capitalists and company
founders, who can cash out more rapidly. It's also a bonanza for underwriters.
But some companies are--almost certainly--being taken public by promoters who
suspect that the firms will never be profitable. Sooner or later, some
investors will suffer huge loses. "Fleecing" is the word that springs to
mind.

Whose moral responsibility is this? Good question. There are others. For
example: Are stock options being overused? Critics believe they may hurt
shareholders by draining a company's wealth.

These are ethical--as well as business--questions. They are hardly being
asked. (An exception: an excellent recent cover story in Fortune magazine.) The
answers aren't easy. As Siegel notes, investors clamor for speculative stocks,
despite well-known dangers. "It's the gold rush, like the 1850s," he says.
"There's a tremendous amount of stock envy." Josh Lerner of the Harvard
Business School says there have been other IPO eras--say, biotech issues a
decade ago--when most companies were unprofitable. It's the nature of the
beast.

Perhaps. But qualifications may be irrelevant. While the boom proceeds,
almost everyone tolerates its excesses, including moral lapses. Winners
outnumber losers. Resentment is muted. But let the boom stumble, and the
climate might alter. Disappointment and losses mount. Some seem to have
profited at others' expense. Recriminations grow. The anger and outrage going
down may be as exaggerated as the indifference going up. Other deflated booms
have followed this cycle: the 1920s' U.S. stock boom; the S&L scandal of
the 1980s; Japan's recent "bubble economy."

In good times, people often do things that--with hindsight--look less
than upstanding. The MicroStrategy case may be misleading. Or it might
portend a larger reckoning.

In spite of the measures adopted by Europe's leaders this weekend aimed
at closing the competitive gap with the US economy, they remain ambivalent
towards America's runaway growth of the last few years.

On the one hand - as pledges to deregulate telecommunications,
liberalise financial markets and kick-start development of information
technology industries reveal there is a grudging but strengthening
acknowledgement that America has been doing something right. The rhetoric is
still couched in mildly disdainful terms that suggests Europe can improve on
the US model. European leaders believe it can achieve an elusive synthesis of
economic success and social cohesion by refusing to go down the "market
society" route of cheap labour and minimal social protection. Yet there is
clearly an acknowledgment that there are lessons to be learnt. In their less
public assessments of US

performance, some continental European officials make no attempt to
disguise their belief that US growth is one of the most egregious examples yet
of "casino capitalism". They believe the elevated demand growth has been fed
not by real growth in productive potential, but by a speculative binge, a
national loss of financial self-control.

Even as they seek to emulate the internet explosion, some of them view
dotcom market fever as an excess that will result in inevitable collapse. Let's
see what people make of this great American model when the downside of social
and economic flexibility leads to rapidly rising unemployment, impoverishment
and social unrest, they murmur.

This posture - reluctant admiration mediated by anticipated
schadenfreude - misses the most important economic lesson of recent
years on both sides of the Atlantic. Without action to make European labour
markets more like the US - the one thing politicians in Europe rule out -
attempts at engineering an innovative, entrepreneurial economic culture will
fail.

The emphasis in European criticism of the US on the social costs of a
freewheeling economic system equally misses the true Weakness in America's
economic resurgence. Ironically, it is also a weakness that European action to
make labour markets more flexible could help to address.

This means that if income in the US and the rest of the world are
growing at precisely the same rate, the US current account will steadily
deteriorate. And over time, this imbalance will need to be addressed by a
steady depreciation in the value of the US dollar, which is a source of
potential instability for the world economy.

Since this phenomenon was first identified, the fundamental imbalance it
implied has not mattered all that much. Throughout the 1970s, 1980s and the
first half of the 1990s, US demand grew at lower average annual rates than the
rest of the world's. The pronounced slowdown in US productivity growth that
began after 1973 ensured two decades of relatively sluggish income growth that
failed to match the European, still less Japanese, performance.

Though it was the cause of much economic soul-searching in the US it had
least had one benefit - the gap in income growth kept the US current account in
broad balance with the rest of the world. When the US enjoyed brief spurts of
growth above the global average - in the mid-1980s for example - the effect on
the current account was dramatic and negative. But these were followed by a
quick reversion to the longer-term pattern of sub-par US growth and either
current account balance or, at worst, small and manageable deficits.

But since 1995, the US has moved into an extended period of
siguificantly faster growth than the rest of the world. The downside of the
productivity acceleration is clearly evident in the rapid deterioration of the
current account - with the deficit now close to 4 per cent of GDP. If this is
indeed a new era of more rapid US growth - or even of merely US growth parity
with the rest of the world - the structural imbalance at the heart of American
demand will loom larger than at any time since it first emerged 30 years
ago.

America's critics say the imbalance represents a chronic US inability to
save enough to finance its investment. In strictly arithmetical terms, this is
of course true, since the savings-investment gap is simply the counterpart of
the current account. But a striking feature of the last few years is that the
gap has been caused not by dwindling savings but by accelerated investment.

In other words, the structural problem is a global one. The US economic
renaissance is simply providing the best opportunities for investors from
around the world. The long-term answer to this long-term problem lies not in
depressing US growth - though of course that is what the Federal Reserve is
forced to do in the short term - but in raising potential elsewhere.

Genuine action by European countries to cut their structural
unemployment by eliminating the penalties against hiring workers will raise
their domestic demand, increasing the attractiveness of European investment
opportunities. For good measure, it would help reduce potentially dangerous
global imbalances and foster that greater international economic stability they
talk so much about. That really would be something to celebrate.

Dangers of excess credit Philip Coggan, FT, 27 Mar 2000

Everyone can agree that two things have been happening in the past five
years. The US stock market has been rising, and so has private sector debt.

However, not everyone would agree on how and if the two phenomena are
connected.

Have consumers been borrowing to put money in the stock market or has
the rise in the stock market meant that consumers have felt more comfortable
with a higher level of debt?

As usual it depends on which statistic you look at. Some would point to
the dangers implied by household margin debt, which is running at 3.5 per cent
of disposable income.

Others would cite the fall in the ratio of household debt to assets from
23.5 per cent at the end of 1994 to 21 per cent at the end of 1999. The latter
statistic clearly indicates the "wealth effect" of rising share prices on
household balance sheets.

Too great a focus on the consumer, however, might be missing the point.

According to Lombard Street Research,
private sector debt jumped from 168 per cent of GDP in 1994 to 205 per cent in
1999.

The biggest culprit was not the consumer but the financial sector, whose
debt jumped from 54 per cent of GDP to 80 per cent during the same period.

Where is all this credit going? It may well have helped fuel the bull
market for equities. After all, the availability of greater credit means
greater demand for equities at a time when supply has been falling.

But that still leaves a puzzle. Why has the rise in stock markets not
"washed through" to the rest of the economy? Excess credit cannot really stay
in the stock market. For every buyer of shares, there is a seller that ends up
with cash.

Only if the corporate sector was a net issuer of equity, could the stock
market really absorb excess credit. But as noted above, corporations have been
reducing the supply of equities through takeovers and share buy-backs.

One possible answer could be that the deflationary forces prevailing in
the past five years have been far more powerful than we thought.

Global competition and technological advance would have led to outright
deflation in the western economies were it not for credit growth. In short, the
money has washed through the stock market after all. And that money has
benefited one sector in particular.

Edgar van Tuyll, a strategist at
Pictet in Geneva,
has found a clear correlation between past episodes of high return sectors (the
Nifty Fifty in the early 1970s or Japanese property in the late 1980s) and
excess credit creation. And the model neatly fits the performance of the
internet sector in recent years.

Mr van Tuyll defines excess liquidity as a situation where credit grows
faster than the economy - as measured by the relationship between commercial
bank credit and GDP.

He believes that, after a period of lengthy economic growth, investors
desert the security of government bonds (pushing yields higher) and pile into
the high risk "flavour-of-the-month" sectors.

Higher bond yields create a problem for most parts of the stock market.
But investor enthusiasm often means that earnings expectations in the
fashionable sectors rise faster than the discount rate. The result is a very
narrow stock market in which only a few shares are going up.

The pattern reverses when interest rates rise fast enough to reduce the
growth of liquidity below that of the economy. Unfortunately, as Mr van Tuyll
remarks, this is not a precise art and it is far from clear how much rates have
to rise to put the brakes on. Certainly the US Federal Reserve's five increases
to date do not seem to have done the trick.

If this model is correct, there are big dangers ahead. If much US
private sector debt is (explicitly or implicitly) collateralised by equity
prices, then quite a small fall in share prices could have a big effect.

We have seen this before in 1994, when leveraged investors were forced
to bale out of bonds or in 1998 when they abandoned high-yield debt. Markets
can temporarily break down.

If the liquidity tap is turned off, there is little in the way of
fundamentals to help underpin some new economy shares (often no earnings or
dividends, sometimes not that much in the way of sales).

Spring is here, hibernation is over, and the bears are out again.
Warnings from Wall Street eminences such as Albert Wojnilower ("Some of us
believe that the speculation has gone so far that there is no easy or painless
way out") and perpetual harangues from Austrian School economists such as Kurt
Richebacher suffuse the air we breathe. Even Goldman Sachs' Abby Joseph Cohen,
whose optimism has always been tempered, suggested raising cash last week.

Making the biggest splash however, at least from a scholarly
perspective, is Robert J. Shiller, a distinguished economist from Yale
University. His book Irrational Exuberance is a wonderful history and
analysis of market booms and busts.

Three times in Wall Street's past 100 years, incredible speculative
binges have grown, and grown, and grown yet again only to give way to wicked
mornings after. There was 1901, most famously the 1929 crash and ensuing
Depression, and the long 17 years of equity stagnation starting in 1966.

Shiller and his fellow doomsayers believe that the current market boom,
in other words madness, has created a bubble - indeed the biggest bubble of
them all - and will be followed soon by at least long-term stagnation if not
outright devastation.

It is not that there is no real basis for optimism, the learned sceptics
agree, with technology breakthroughs fundamentally transforming our economy,
but the Wall Street hype has transformed rational optimism to market lunacy,
or, in polite and now overused terms, "irrational exuberance".

Heaping ample doses of blame on Wall Street analysts, strategists and
brokerages, as well as the purveyors of optimistic news such as Business Week,
CNBC and many others, including Alan Greenspan's Federal Reserve, the bear pack
accuses these folk of perpetuating a huge and unsustainable swindle on a
gullible investing public.

They have sold unsuspecting innocents on such falsehoods as "the new
economy", "in the long run stocks always go up", "inflation is dead", "the
traditional valuations can't be used any more". And, the one I like best -
conveniently used to explain away every bubble in history (including the
miracle of Japan in the excessive 1980s): "It's a new era".

The bears make convincing cases that valuations are ridiculously high,
volatility has reached dangerous levels, many marginal companies are selling at
levels way beyond blue sky, and a significant number of investors are, to say
the least, managing their personal finances imprudently.

Conceded, but, more importantly, so what?

The problem with these sceptics is that they don't answer the two most
important questions: when will the bubble burst and the bull die? And what will
follow?

Remember that the legendary Greenspan "irrational exuberance" speech was
made in late 1996, almost three and a half years back and, more significantly
for investors, some 5,000 Dow Jones points ago. For the most part, the same
bears were in full roar back then.

Indeed, some of the naysayers have been crying danger since the early
1990s and urgently urging equities avoidance. How would you like to have missed
the last five years or more by heeding their call?

What distresses investors most is the periodic "pockets" of suddenly,
steeply declining equity prices. These bouts of dizziness seemingly do the same
percentage damage in a fraction of the time that was needed in the past to
correct excesses.

Think of the reaction to the Asian crisis in the fall of 1997, and of
the profound fears stirred after the Russian default, along with the
near-demise of Long-Term Capital Management, the hedge fund replete with Nobel
laureates, in autumn 1998.

The bulls disappear, the bears give a roar or two, and famous market
technicians wring their hands on cable television and incite panic selling - a
sure sign that we are near the bottom.

So what if the bull goes on for another five years? It could happen. It
has always seemed to me that the first rule of investing and trading is to know
what you don't know.

Of course, the bull market will end. I said so myself on these pages
nearly five months ago. But neither the bears, nor the bulls, nor I know when
or what will trigger its demise.

It may or may not have anything directly to do with the economy; it may
be geopolitical or something seemingly far removed, but, whatever its cause, it
will be seen only in hindsight as the catalyst for fundamental mood change.

Yet remember, please, that the greatest gains in previous speculative
binges have occurred in their final years.

The second question, of course, is: what will happen after the markets
top? What if it is not the devastation of the 1930s but rather the stagnation
of the 1970s (or the "golden recession" of 1990s Japan)?

After all, it really is a new economy, it really is the information age,
there really is globalisation and the world's central bankers do indeed have
the benefit of the knowledge gleaned since the Depression.

During the so-called "sober seventies", bear market and all, there were
areas of equity success amid overall broad trading ranges. And certainly, if
warranted, a portion of assets could be shifted to fixed income of one sort or
another.

Devastation, of course, is possible. The contributing factors are there
for all to see: personal debt, public debt, leveraged derivatives, the Nick
Leesons of the world - I need not go on. But is it a probability, or merely a
possibility?

When have the known dangers caused anything more than needed adjustments
throughout financial history? It is the unknown, the wildness that lies in
wait. Or, to put it another way, when the excesses are so great and so
commonplace that no one pays them any heed: that is the time to watch out.

Yes, the bears' growling ought to be considered, but as before, the
ageing bull - albeit prone to the maladies of old age such as the distressing
corrections that come along - just may survive another year. Or two. Or three.
Or more.

Alfred H. Kingon is a former assistant secretary of the US Treasury,
secretary of the cabinet during the Reagan administration, and was US
ambassador to the European Union from 1987 to 89. He is principal of Kingon
International, an investment firm.

Alan Greenspan faces long odds in trying to nudge the stock market to
where he'd like it to go. The chairman of the Federal Reserve has argued that
the buoyant market--by making Americans feel so much wealthier--has triggered a
consumer spending spree that threatens inflationary wage pressures. To avoid
that, Greenspan's Fed has been raising short-term interest rates. Yesterday, it
increased the so-called Fed Funds rate to 6 percent. This was the fifth
increase since June 1999, when it was 4.75 percent.

The idea is to dampen spending and the ravenous appetite for stocks.
Anyone who thinks this will be easy should read "Irrational Exuberance," a new
book by Yale University economist Robert J. Shiller. Beyond arguing that the
present market is a "speculative bubble," Shiller contends that investor
psychology is so given to herd behavior that it's almost impossible to
manipulate or even influence. The market can "go through significant mispricing
lasting years or even decades."

We know this from history. In the 1920s, stocks more than tripled. By
1929, they were highly overvalued; the economy was about to collapse.

"Basically, a giant Ponzi scheme"Fraud which has lost $50bn
Bernard Madoff has been charged. Among the banks which have been hit are Britain's HSBC and RBS, Spain's Santander and France's BNP ParibasBBC 15/12 2008

Where is the S-word (Stagflation)?The high debt levels actually make deflation LESS likely, not more likely, because the current monetary system - the world's greatest-ever Ponzi scheme - could not survive a bout of genuine deflation.Steve Saville, 6/2 2006

Charles Ponzi wasn't the first to try it, but he has joined Dr. Bowdler
and Captain Boycott among those whose names will forever be terms of abuse. And
the classic scam that bears his name -- using money from new investors to pay
off old investors, creating the illusion of a successful business -- shows no
sign of losing its effectiveness.

Robert Shiller's terrific new book, "Irrational Exuberance," contains a
brief primer on how to concoct a Ponzi scheme. The first step is to come up
with a plausible-sounding but complicated profit opportunity, one that is
difficult to evaluate. Ponzi's purported business involved international
postage reply coupons. In a more recent example, Albanian scammers convinced
investors that they had a profitable money-laundering business.

The purest examples of New Economy businesses are those that, while not
actually generating a profit, command a mammoth stock market capitalisation.
Pacific Century CyberWorks - which, at the ripe old age of 10 months, has just
acquired Hong Kong Telecom - is a worthy example. Others include Akamai,
Amazon.com, Ariba, Buy.com, Level 3 Communications, Priceline.com, Red Hat, VA
Linux Systems and Verticalnet. The 10, a mere sample, have a combined stock
market capitalisation of Dollars 176bn.

Federal Reserve Chairman Alan Greenspan thought a "bubble" existed in
the U.S. stock market as far back as 1994, two years before his warning about
"irrational exuberance" among investors prompted a U.S. lawmaker to reprimand
him for causing a slump in global stock prices.

Transcripts released Wednesday of meetings of Fed policymakers in 1994
show that Greenspan expected to "prick the bubble in the equity markets" when
the Fed began raising interest rates for the first time in five years in
February 1994. The Fed raised its key federal funds rate a total 2.5 percentage
points that year to prevent the economy from overheating.

Greenspan, stung by the furor that followed his "irrational exuberance"
speech now refuses to say publicly whether U.S. stock prices are inflated. He
argues instead that "to spot a bubble in advance requires a judgment that
hundreds of thousands of informed investors have it all wrong" and that
"betting against markets is usually precarious at best."

The Dow Jones Industrial Average has climbed 57% since Dec. 5, 1996,
when Greenspan posed a rhetorical question in a
speech to the American Enterprise Institute: "How do we know when
irrational exuberance has unduly escalated asset values, which then become
subject to unexpected contractions as they have in Japan over the past
decades?" The index is about 260% higher than its level in February 1994, when
the Fed began its last aggressive campaign to cool the economy.

Back then, Greenspan had no trouble describing rising stock prices as
symptomatic of a "bubble." On March 24, a month after the Fed raised the funds
rate a quarter percentage point to 3.25%, Greenspan told his colleagues: "When
we moved on February 4th, I think our expectation was that we would prick the
bubble in the equity markets. What has in fact occurred is that...while the
stock market went down after our actions on Feb. 4, it went down quite
marginally on net over this period."

At the March 24, 1994, meeting, he called the 1987 U.S. stock market
crash "perhaps the only major stock market crash in history that actually was
beneficial to the economy." The crash, he said, "stripped out a high degree of
overheating and sort of got right to the edge of where the overheating got into
the muscle of the economy and stopped."

Panic in the bond markets; rumours of collapsing hedge funds and huge
losses on Wall Street. Hang on - following the near-collapse of Long-Term
Capital Management just 15 months ago, this was not supposed to happen
again.

Obviously, whatever temporary seif-restraint hedge
funds, banks and brokers exercised in the aftermath of that scare has
dissipated and greed has regained the upper hand. Over the past couple of
months, these folk have colleetively placed a massive bet on a steepening of
the US yield curve by huying eurodollars and short-dated notes and shorting
long dated bonds.

That gamble went disastrously wrong this week as the
Federal Reserve increased interest rates and the US Treasury announced a $30bn
debt retirement scheme, concentrated on the long end. That provoked a stampede
into 30-year Treasuries and led to a sharp inversion of the yleld curve.

Perhaps the Treasury deserves some criticism for not
spreading its buy-back across the maturity range. But the operation itself was
weil flagged. The hon's share of the blame must go to the traders. According to
the US Commodity Futures Trading Commission, "large speculators" (meaning hedge
funds) had built up an underlying $7bn short position on the 30-year bond, the
biggest since its records began.

Clearly the lesson of LTCM - that liquidity risk is just
as dangerous as any other financial risk - has been forgotten only too quickly.

The only comfort is that this time the pain seems to be
spread more evenly across Wall Street, so the fall-out should be more
containable.

We are about to rewrite history. Unless a recession begins in the next
few days, this boom will soon become the longest in the American experience. In
February, it will have lasted 107 months. The current record is 106 months
between February 1961 and December 1969, according to the dating of business
cycles by the National Bureau of Economic Research. By and large, Americans are
behaving as if recessions are a relic of the past, even though everyone must
realize that the boom will end someday--and might end badly.

As with all records, people will celebrate and assert bragging rights.
President Clinton always claims credit and will almost certainly repeat the
claims in tomorrow's State of the Union. Alan Greenspan, chairman of the
Federal Reserve Board, is idolized for his presumed role. The murkier truth is
that the boom's causes remain obscure and, to the extent they can be
identified, reflect a protracted and largely nonpolitical process.

Low inflation has been the critical catalyst. In the past, rising
inflation has doomed expansions through higher interest rates, increased labor
costs and squeezed profits. Consumer spending, housing construction and
business investment all suffered. Yet, inflation now remains tame. By various
measures, it's running between 1 percent and slightly more than 2 percent a
year. This is lower than in 1990 (between 4 percent and 6 percent by the same
measures) and defies the conventional tendency of inflation to worsen as the
economy "heats up."

To explain tame inflation, I'd cite three factors:

* The Fed: Paul Volcker, chairman of the Fed between 1979 and 1987,
crushed inflationary expectations. In the 1960s and 1970s, these had become
ingrained. Companies raised prices because they expected customers would pay.
Workers expected pay raises to compensate for higher prices--and then some. The
Fed blessed the process by creating more money. Its permissive policies rested
on the prevailing--but faulty--theory that a bit of inflation aided economic
growth. By 1980 inflation had reached double digits. Volcker tightened money,
increased interest rates and caused a savage recession. In 1982 unemployment
neared 11 percent. Though brutal, the downturn stifled wage and price
increases. By 1983 inflation was 4 percent. President Reagan sanctioned
Volcker's policy by muting criticism. Since then, Greenspan's Fed has pursued
"price stability" and has raised interest rates (as in 1994) to prevent
inflation's upward creep. Presidents Bush and Clinton have emulated Reagan's
self-restraint.

* Better Management: Through the 1970s, corporate managers were rarely
fired. Their job tenure rivaled university professors'. In the 1980s, things
changed. Managers became vulnerable to job loss for many reasons: the
recession; foreign competition; deregulation in the airline, trucking and
communications industries; "hostile" corporate takeovers; the growth of new
discounters (Wal-Mart, Home Depot). Self-preservation made managers more
ruthless. They cut costs to raise profits. Old plants were shut. Layoffs and
"downsizings" became common. Again, the immediate consequences were often cruel
and (as with Volcker's recession) widely deplored. But the lasting effect was
less inflationary behavior.

* New Technology: As everyone knows, business investment in computers
and communications has exploded. The presumption is that these investments
enable companies to do things faster and cheaper--they raise "productivity."
Firms can minimize unneeded inventories or speed the processing of customer
orders. Higher productivity can be magical. If a company improves productivity
3 percent, it can raise wages 3 percent without increasing prices or
sacrificing profits. And productivity has improved. In recent years, it's
approached 3 percent a year, up from 1.6 percent in the 1980s.

We're enjoying the fruits of purged inflationary psychology. Luck may
also have helped. Economist John Makin of the American Enterprise Institute
notes that the Asian financial crisis--which first seemed to threaten
recession--may have prolonged the boom. It reduced inflationary pressures by
"cutting the [worldwide] demand for raw materials" and stimulating cheap
imports into the United States from debtor countries. It also prompted the Fed
to cut interest rates in late 1998, providing "a tremendous tail wind for the
U.S. economy and stock markets."

There are many plausible reasons that the boom won't last forever.
Productivity gains could prove temporary. Inflation might increase, with low
unemployment pushing up wages. The Fed is already sufficiently worried that
it's raising interest rates. Or the prevailing boom psychology might prove
fatal. Undeniably, Americans have gone on a spending spree. Since 1991, for
example, personal after-tax income has risen 47 percent (with no correction for
inflation); meanwhile, consumer spending has risen about 57 percent. The gap
between the two--financed by borrowing or selling stocks--totals almost $400
billion annually. Spending can't perpetually outstrip income.

One reason it has is the effusive stock market. Consumer confidence has
risen with consumer wealth, real or on paper. Much of the market's increase
reflects genuine economic gains (lower inflation, higher profits). But some
reflects sheer speculation.

In a recent report, analyst Steve Galbraith of Sanford C. Bernstein, an
investment house, confirmed that there's less long-term holding of stocks--and
more trading for instant profits. In 1999 the Nasdaq's turnover was 221
percent. This meant that the market's total number of shares was bought and
sold not just once during the year but more than twice. In 1990 turnover was
less than half that. "Of the 50 stocks with the highest returns [increases] on
the Nasdaq only 15 made money," writes Galbraith, and "the average turnover in
this group was 600 percent" (shares were bought and sold six times). On the New
York Stock Exchange, turnover has nearly doubled since 1990 to 79 percent. Not
surprisingly, margin debt--borrowing by investors to buy stocks--jumped 62
percent in 1999 to $229 billion.

So, the boom is making history, but its history isn't finished. We'd all
like it to glide along forever. Perhaps it has years to go. But it could be
sowing the seeds of its own destruction.

It is unlikely that the new elite of central bankers and technical
advisers has learned how to avoid financial bubbles

The pendulum of fashionable financial opinion has swung from predictions
of doom round the time of the emerging market crisis little more than a year
ago to one of euphoria. Political leaders are more restrained than financial
market enthusiasts. But even Larry Summers, US Treasury secretary, has
delivered an upbeat message.

He is not only optimistic about the US, which will soon announce the
longest ever period of sustained economic expansion. He is also, by his
standards, relatively optimistic about other developed countries after years of
criticising them for not doing enough to sustain growth.

He envisages a soundly based upturn in Europe and at least some
improvement in Japan, even if the latter does not go far enough. It is just
when such optimism is in the air that one should keep a weather eye for
trouble.

The threat is the familiar one of an overvalued US stock market, which
finds a less extreme echo in the other bourses of the world. But there are two
subtleties that have escaped attention.

First, the financial bubble is not simply a sideshow in a booming US
real economy. It is an essential part of that boom. The private sector is
running an unprecedented financial deficit, which can only be maintained
because the soaring value of financial assets - and to a lesser extent real
estate - provide the impression of ever increasing wealth. Should that change,
the proverbial hard landing would not be far away.

Second, it is possible to say in the case of most economic threats
whether the potential problem is one of inflation or recession. But when the
threat comes from financial markets, the problem is twofold; first an
unsustainable inflationary boom, which is then followed by a bust.

Financial bubbles have been a feature of capitalism from the beginning
and it is unlikely that the new elite of central bankers, advised by
econometricians, has learned how to eliminate them.

The interesting question is how stretched the bubble is, and what the
effects are likely to be when it bursts.

An analyst at Phillips & Drew, Alistair McGiven, has made an attempt
to quantify the degree of Wall Street overvaluation. By traditional measures
this is extreme.

The dividend yield on the S&P 500 is much lower than at any time
since 1910. So is the earnings yield, with the exception of the depression year
1932, when presumably earnings collapsed even faster than equity prices.

The novel feature is his attempt to adjust for forces in the new economy
that may plausibly influence fair values and so justify current market
levels. He does so by adjusting these yields for more optimistic market
expectations about inflation, a lower equity risk premium and faster trend
output growth. He maintains that adjusted measures have been able to predict
the market except for the last, fabulous couple of years. On the basis of these
adjusted earnings and dividend yields, he estimates the US stock market is
still about 50 per cent above fair value.

What I find fascinating is that Neil Williams, the global strategist of
Goldman Sachs, which has hitherto taken a more optimistic view, is now
beginning to issue warning noises. His analysis suggests that the global equity
market looks expensive relative to past levels but not excessively
so, if one excludes the information technology sector. In statistical
terms, the valuation of the market is about one standard deviation
richer than the recent average.

Turning to IT valuations, he admits that these look very expensive on
any standard measure, but estimates that future earnings growth implied by
current valuations are not far out of line on what technology has
achieved in the last five to 10 years.

Maybe. But when he adds up the earnings growth rate necessary for both
the IT and non-IT sectors to offer a decent equity risk premium, he
finds that the required growth rate in market earnings comfortably
exceeds the likely growth rate of the wider economy. Although he remains
neutrally weighted towards stocks, he adds that they are
nevertheless vulnerable to unpleasant surprises on either the earnings or
the interest rate fronts. Or as I would summarise it, the risks are on
the downside.

Coming to aspects where I feel more at home, the Goldman Sachs central
simulation suggests that the share of global GDP taken by profits would have to
rise to 19 per cent within 10 years to justify current valuations - a level
unknown for a quarter of a century.

Supposing we look back still further, what do we find? For the US alone,
the share of profits in GDP was higher for a period in the mid 1960s than it is
today. But both the world and US economies are far more competitive, and there
are more pressures on profit margins, than 30 or 40 years ago. So it is
difficult to see a sustainable increase to anything like these levels. Indeed,
the share of domestic non-financial profits has been gradually declining
recently.

Happily tallying up your profits on the stock of Microsoft and Intel?
They're nothing compared with what Microsoft and Intel are earning on their
stock investments.

The companies' profits from investments-which are entirely separate from
their operating income-are eye-popping: Intel recently booked $327 million
(E323 million) inquarterly earnings from sales of stock it owns.
Microsoft, in its latest quarterly report, had $773 million in profits from
selling such investments.

It isn't just American technology companies that are making lots of
money in the stock market: General Electric Co. and Delta Air Lines, among
others, are making significant investments in other companies, often
venture-stage enterprises, then sometimes realizing nice gains when the stocks
of those companies climb. To the extent the stocks are sold and the gains
realized, they flow to the companies' bottom lines.

While supercharging the profits of some big U.S. companies, these
stock-sale profits raise an interesting - and to some a question. Are stock
prices giving a significant boost to fits that are fueling the euhoric stock
market? Or, put another way, stocks to some extent feeding on themselves rather
than on real growth in their businesses?

That is the worry of some market watchers who analyze company earnings.
The contribution these investments make some companies' earnings may be
difficult to repeat, they note, and may mask be quality of the underlying
business. And if the stock market were to correct sharply and the market for
hot IPOs cool off, many of those gains would dry lip or perhaps even turn to
losses.

The US exampleFT-leader, January 4, 2000

As the US economy speeds into the New Year in a blaze of
self-congratulatory euphoria, the rest of the world seems unable to make up its
mind whether to look on in admiration or alarm.

Reform-minded politicians and economists in Europe and Asia hold up US
economic success as a model for change in their own countries. The virtues of
flexible labour markets, fleet-footed capital markets and a low-tax,
deregulated business climate, point the way ahead for their own economic
renaissance, they argue.

Critics reject the notion that there is anything to be learned from this
transitory US success. The strength of the expansion, they say, is down to
nothing more than speculative over-excess, built on unstable internet hype. It
will, they predict, end as all such periods have ended, in a spectacular crash
that will undermine once and for all the notion that the so-called US model
amounts to more than casino capitalism.

There is clearly a risk that speculative excess may undermine US
performance perhaps even early in the new century. Less than a decade ago it
was, after all, still fashionable to tout Japanese virtues of long-term
planning, stable banking relationships and lifetime employment as the way
ahead. What is most striking this time in the US is the context of its economic
performance - the exploitation of modern technologies that are raising
productivity and living standards. In a number of critical fields the US has
shown that its market-oriented flexibility is highly effective at managing
change and producing prosperity.

America is clearly able to operate its economy at a lower level of
unemployment than can most continental European economies. The jobs created are
not all hamburger-flipping minimum wage drudges. The fastest growing area of
job creation in the last few years has been in the high-tech sector. And while
inequalities have certainly widened, the last three years have produced the
first real gains in income for average and low earning Americans. Europeans
should look with respect at the ease with which US companies are able to hire
and dismiss workers. US success should also encourage them to continue to roll
back the multilayered social programmes that raise the cost of working.

The story of a bubble  and its aftermath By
definition, a market bubble is not a very obvious affair. If the man on the
street begins to see what by all accounts is a bubbly market, he will act
rationally, or so the academics believe, and find a safer haven for his
savings. Which means that in principle, if markets were truly rational and
relied on tried and trusted measures of investment value, then bubbles could
never develop.

The US bull market of the past two decades has been driven by two broad
forces: a revival in corporate profitability, and the decline in inflation that
has allowed investors to attach higher valuations to that stream of profits.
The latter trend is substantially complete: inflation is close to zero and
valuations have shifted from cheap to expensive. That leaves earnings growth as
the prime determinant of future stock market performance.

No worries here, say Wall Street's finest. US analysts expect S&P
500 earnings to jump a blistering 17 per cent in 2000, according to First Call
- the same as this year, which saw the rebound from the emerging markets
crisis.

Even the more sober, top-down strategists forecast growth of 10 per
cent. Investors' long-term expectations are scarier still. Assuming an
(optimistic) equity risk premium of just 2 per cent, research group BCA
calculates that earnings would have to rise by nearly 15 per cent a year for
the next 10 years and by 8 per cent a year over the next 30 to justify the
market's current heights.

Subtract inflation and that implies real growth of more than twice the
historical average.

It is hard to see how these targets can be reached, however fervently
one believes in new paradigms.

Granted, the US is in a long-run, technology-led upturn that is boosting
productivity and thus the economy's non-inflationary speed-limit - from say,
2½ per cent to 3½ per cent in real terms. That is a huge
achievement.

But, for the corporate sector at least, it is being balanced by a number
of other factors. The first is labour costs. While hourly wage growth is
subdued at 3½ per cent, once other forms of compensation are taken into
account overall labour costs are growing at closer to 5 per cent - exceeding
productivity growth of around 4 per cent. On top of that, many companies face
persistent downwards pressure on prices, from computers to detergents.
Corporate debt is rising and so are interest payments as a percentage of
profits, after having dropped sharply for most of this decade. Finally, all
that high-tech capital investment is pushing up depreciation charges.

National incomes data based on tax returns - a broader measure than the
earnings of S&P 500 companies alone and one less susceptible to accounting
shenanigans - suggest US corporate profit margins actually peaked in 1997 after
rising sharply for nearly a decade. Intuitively, that makes sense: over the
long haul, corporate profits simply cannot grow faster than the economy.

To be fair, the S&P 500 should grow more rapidly than the corporate
sector as a whole. Not only does it contain many of the country's biggest and
most dynamic companies. About a third of their earnings come from overseas,
where competitive US groups can win market share.

But it is unlikely that those factors will be enough to bridge the gap
between domestic economic growth of, say, 6 per cent (3½ per cent real
growth and 2½ per cent inflation) and investor expectations of many more
years of double digit earnings increases.

Alan Greenspan's warning on Thursday that banks should set aside
reserves in case of a market collapse was just the latest in a series of hints
the Fed chairman has given about overvaluation of equity markets. Yet, together
with some unfavourable figures for US producer prices, it was enough to give
the markets a serious jolt. Investors are getting jittery about the US
market.

The gradual upward creep of US bond yields over the past year was the
first sign that the markets were getting wind of a change in economic
conditions. Over the last few months, equity investors have also become more
cautious. Now both markets are uneasy about the prospect of further interest
rate rises.

The monetary policy decision that Mr Greenspan faces is fairly
straightforward. The two quarter-point interest rate rises over the summer have
not stemmed demand. Higher energy costs helped push producer prices up by 1.1
per cent in September, although much of this rise can be explained by one-off
factors in the tobacco and auto industries. Retail sales are showing no
slowdown. Unemployment looks set to fall. A further rise in interest rates
would be wise.

But in a country with a stock market which is by any conventional
measure overvalued, and with a large and rising current account deficit (the
consequence of an imbalance between private sector savings and investment), any
rise in interest rates has implications that go far beyond the control of
prices. The reaction to Mr Greenspan's speech shows once again how sensitive
the markets are to any hint of a change in monetary policy.

The US economy, for all its strength, is highly vulnerable to a market
setback. It relies on foreign investment to finance the gap between domestic
savings and investment. This has so far been forthcoming, because of the good
performance of US assets, and the sustained strength of the dollar.

But should either of these conditions change, the US may fall out of
favour. Already Japanese investors have been turning away from US Treasuries
because of the slide in the dollar against the yen.

Yesterday's falls in the stock market and the dollar could make
investors elsewhere more wary too. If the US were to experience a big market
crunch, interest rates on assets would have to rise to attract foreign funding
back into the country. This would have a contractionary effect. In addition,
the spending spree of US consumers, prompted as it was by the wealth effect of
higher equity prices, could come to an end. The Fed would of course react to
limit the damage, but nevertheless the correction could be very painful.

Yet it is hard to see how the Fed could have avoided this problem.
Monetary policymakers are ill-equipped to deal with imbalances in asset prices
or the exchange rate, because these react to interest rate movements in an
unpredictable way. Mr Greenspan has chosen to base monetary policy decisions on
domestic price conditions, rather than trying to manipulate the markets
directly. His efforts to keep the lid on asset prices have been limited to
cryptic remarks in speeches, with the result that his pronouncements have
attained an almost mythical status among investors.

The Bank of England faces similar difficulties, although on a much
smaller scale. The economy seems to be adapting fairly well to the sustained
strength of sterling, so much so that an interest rate rise has been necessary
to keep demand in check. Whilst most of the economy is now on an even keel,
though, the housing market has been accelerating. The Bank's dilemma is that a
rate rise large enough to control house prices would stifle the rest of the
economy.

Continental Europe shares the US phenomenon of rising bond yields, but
its position at an early stage of the economic cycle means that its policy
choices are very different.

High yields

Bond yields are high compared with inflation. This, together with the
appreciation in the euro over recent months, amounts to a de facto tightening
in monetary policy. Given that inflationary pressures are virtually absent
across most of the euro-zone, this means that the European Central Bank may not
have to move rates by as much as the markets are expecting. Bond yields may yet
ease again. And the wave of mergers and acquisitions taking place within the
euro-zone are likely to support European equity valuations for some time to
come.

Yesterday's market turbulence could turn out to be short-lived. Yet it
is a further reminder of the delicate task facing Alan Greenspan. Does he try
to deflate the markets gently, and risk triggering a crash - or does he say
nothing, and stand by and watch a bubble inflate?

The Dow Jones Industrial Average seems ready to hit 10000 again. But
this time there's no call for champagne and noisemakers of the sort that
greeted the stock market's first close above what the public called "Dow
10,000" in March. That's because this time, the milestone is poised to be hit
on the way down, not up.

But investment pros say there's no reason to panic. "If you're invested
for the long term, it's not going to be unusual to see stocks swing 20% off
historic averages," says David Bugen, an investment adviser in Chatham, N.J.
"It's painful, but unfortunately part of the price of investing in equities is
short-term volatility."

Another thing to keep in mind about the daily point moves: Because the
Dow is so high, it's a lot easier for it to move 100 or 200 points these days
than in the past. In 1987, a 500-point decline represented a fall of well over
20% -- a crash by any measure. But the equivalent percentage drop today would
require a fall of 2,000 points. In other words, don't get too excited by a
startling-looking decline of 200 points, or even 500 points. On their own, they
are fairly routine declines.

"Even with the pullback to 10000," investors still have more than a 50%
gain, he says. "Even if we see a 20% pullback, it would still leave us at more
than 20% above where we were when Greenspan spoke those words." Mr. Stovall
adds, "If you had gotten nervous back then, you would have missed out on the
nice rise of the overall market."

Eric Lake, who runs his own commodity-trading-advisory and
money-management service (www.DowGuru.com), said three times this summer the
industrial average just touched and failed to break a trend line that he traced
back to Black Monday. Most ominous of all, the average peaked on Aug. 25,
the same date it peaked in 1987. Noting that the market crashed 55 days after
its peak in 1929 and 1987, Mr. Lake said, "Oct. 19 is the target date: 55 days
out."

A miraculous error
Martin Wolf, FT, September 29 1999 The
Federal Reserve inadvertently allowed unsustainable growth in the US, but this
helped to offset the collapse of demand elsewhere and avoid deep world
recession

The International Monetary Fund is hardly the first to question the
sky-high valuation of US stocks, but its arguments are no less convincing for
that. The fund agrees with the bulls that the near-tripling of US equities
since 1995 can probably be justified by lower interest rates - which boost
valuations by increasing the discounted value of future dividends.

But now that US rates are rising again, how come shares are still going
up? This requires one of two things.

The first is an increase in real dividend growth, which is unlikely
given the maturity of the current economic expansion and the fact that
dividends are already growing at close to historic highs.

The other is a further decline in the equity risk premium, which is hard
to square with rising spreads in fixed-income markets.

The IMF notes other factors that might justify current prices, such as
robust productivity growth and greater popular participation in the stock
market. But it does not find them hugely convincing. And it warns, justifiably,
that any US correction would drag down international markets, whether they are
intrinsically overvalued or not.

But while the fund's logic is sound, its conclusions were yesterday
cheerfully dismissed by investors, just as they have ignored occasional gloomy
mutterings by Alan Greenspan, Federal Reserve chairman.

Just what might trigger a correction neither the IMF nor Mr Greenspan
seem prepared to reveal.

Has Alan Greenspan joined the ranks of bubbleologists? Bursting Mr. Greenspan's Bubble By James K.
Glassman and Kevin A. Hassett. Wall Street Journal,
September 3, 1999Mr. Glassman and Mr. Hassett, fellows at the
American Enterprise Institute, are the authors of "Dow 36,000," just out from
Times Books.

New York Stock Exchange member firms customer margin accounts,
which allow investors to borrow against a portion of their portfolios to
purchase additional stocks, surpassed $170 billion in April, reaching $178
billion in May before edging back by about $1 billion in June. That represents
a 25 percent increase versus December, 1998 CNBC
99-08-09

IMF Concludes Article IV Consultation with the United States On July
30, 1999Although the performance of the U.S. economy had been
remarkable, Directors noted the contribution of possibly transitory factors and
cautioned that there were significant risks. Principal among these is the
danger of a substantial and abrupt decline in U.S. equity prices.
........ more

The real question facing the U.S. and
global economies whether the U.S. stock market bubble - and yes, it is a bubble
- will be deflated endogenously (that is, by natural market forces) or by the
Fed's ever-so-gently raising interest rates. John H. Makin, American
Enterprise Institutehttp://www.aei.org/eo/eo10752.htm

Decade of Greed II, by Robert J. SamuelsonWashington Post,July 14, 1999An intriguing
paradox of the 1990s is that it isn't called a decade of greed. Only the 1980s
have acquired that stigma, even though the advance of individual wealth, the
explosion of personal fortunes and the obsession with money in this decade all
rival or exceed what happened in the last.

Greenspan also warned of a possible ``euphoric'' rise in stocks
fueling increased consumer spending. ``If new data suggest it is likely
that the pace of cost and price increases will be picking up, the Federal
Reserve will have to act promptly and forcefully so as to preclude imbalances
from arising that would only require a more disruptive adjustment later,'' he
said.

The meeting of G7 finance ministers and central bankers showed that the
world's economic leaders, rightly, remain concerned about the global outlook.
The big economies pledged to continue to support domestic demand, to bolster
world growth.

This will take little effort in the US. In the first three months of
this year the economy expanded by a remarkable 4.5 per cent, following growth
of 6 per cent in the previous three months. The IMF forecasts growth of 3.3
cent this year.

This may well turn out to be on the low side. With inflation remaining
weak and labour costs subdued, there is no sign that the Federal Reserve
intends to raise interest rates soon, despite such strong growth. If this
continues, equity valuations may begin to look less stretched.

It is the robust US that has kept the world economy turning. Last year,
US private sector spending accounted for almost half the increase in world
demand.

This year, Japan will suffer recession, and growth in the eurozone will
be weak - particularly in Germany and Italy. But such an uneven balance of
world demand brings substantial risks. US consumer demand, by sucking in
imports, has helped emerging markets to recover, and Japan to avoid collapse.

But the US current account deficit cannot continue to grow indefinitely
unless investors have an insatiable appetite for US assets.

Moreover, US consumers have financed their spending by running down the
savings rate to negative territory. This cannot continue indefinitely.

Policymakers must hope the path of adjustment for these imbalances is a
smooth one. But a sharp fall in the US stock market could upset this. So too
could a sharp fall in the dollar.

For the moment, a decline in the dollar remains unlikely. Japan's fall
may have reached bottom, but the economy will be stuck in recession this year.
With strong US growth and weak euro-zone activity, the dollar's strength
against the euro also looks fully justified.

Still, with the emerging markets crisis at last receding, the great
uncertainty now is whether Europe and Japan can recover, to take the strain off
the US consumer, before the US economy slows.

Alan Greenspan, Washington, May 6The phenomenal performance
of the U.S. economy in recent years - largely a function of increasing
productivity - could end unless ``imbalances'' in the economy are addressed,
Federal Reserve Board Chairman Alan Greenspan said.

Greenspan also said the ``worst of the crisis abroad'' may be over, and
that many people think stock prices are overvalued. ``Of most concern is how
long this remarkable period of prosperity can be extended,'' Greenspan said in
the text of remarks to the Chicago Fed's annual Bank Structure Conference.

- There are imbalances in our expansion that, unless redressed, will
bring this long run of strong growth and low inflation to a close,'' he said. A
pickup in productivity "does seem to explain'' much of the favorable inflation
news in recent years. While it's led to excess capacity that is holding down
prices, the savings to companies are boosting corporate earnings. Perhaps too
high, he suggested.

The revaluation of business assets due to technological progress "has
induced a spectacular rise in equity prices that to many has reached well
beyond the justifiable,'' Greenspan said.

- Billionaire investor Warren Buffett believes the U.S. stock market has
seen virtually unprecedented increases in recent years and is in a "dangerous"
period that could see stock values drop sharply. Stocks have risen
"terrifically" over the past 15 years, driven higher by lower interest rates
and rising return on equity, Buffett told the ABC News "Nightline" program
Tuesday.

"After a while the very act of stocks going up starts drawing in other
people who get excited about the fact that their neighbor made some money ...
and that's when you get into the dangerous periods," he said.

Asked when the bubble would burst, Buffett said, "You never know. You
know that valuations are high, by historic standards. You know that the level
of speculation is high, by any historic standards, and you know that it doesn't
go on forever ... but you don't know when it ends."

Not in 40 years has so much of the stock market's advance been so
concentrated in just a handful of stocks. In 1998, the Standard & Poor's
500-stock index advanced 26.7%. But the average stock in the index gained just
10.8%.

The difference results from the extraordinary gains of the largest
stocks, which have the biggest impact on the capitalization-weighted index. And
the largest stocks are, by and large, fast-growing companies for which
investors are paying ever higher price-to-earning ratios. Salomon Smith Barney
estimates that the 50 largest companies collectively returned 38% in 1998.

FT leader 98-09-19 excerpts The world's two largest economies
are now locked in a strangely symbiotic embrace. The US is the world's biggest
debtor and spender; Japan is the biggest creditor and saver. From these
diametrically opposed positions, the respective economies have nonetheless
reached a state where the effectiveness of monetary policy is subject to severe
constraints.

Japan is already close to a serious deflation, with the 10-year bond
yield falling this week to a scarcely believable 0.7 per cent. No one expects
the recent cut in Japanese overnight interest rates to 0.25 per cent to impart
much stimulus to the economy, though it will provide modest relief to the
troubled Japanese banking system. Monetisation - the modern version of the
printing press - by now looks imminent.

In the US, meantime, the collapse in the savings rate to 0.6 per cent of
disposable income in the second quarter, compared with its customary level in
the 1990s of between 4 and 6 per cent, is worrying. It means that interest rate
cuts may be of limited help in promoting further borrowing and spending,
especially when bankruptcies are running at record levels.

Capitalism is not in a global crisis. But there are difficult times
ahead - and not just for the emerging markets.

BBC 98-09-18:

A respected economic forecaster has warned that the world economy could
stall or even contract over the next 18 months as the financial crisis that has
hit Asia and Russia spreads throughout the world.

The Economist Intelligent Unit (EIU)
has issued one of its gloomiest ever reports on the outlook for economic
growth. Te EIU believes that, even if the financial crisis does not deteriorate
further, the world's economy is heading for a rough ride.

And there is a real danger that the global financial crisis could get
significantly worse, with problems in Asia and Russia spreading to Latin
America according to the research.

If that happens the world eonomy could grind to a halt or slip into
recession.

However the EIU does not believe that the economy will plunge into a
prolonged recession lasting several years as it did in the 1930s in the wake of
the Wall Street crash.

The EIU believes the key factor will be how the US Federal Reserve
reacts to the financial problems and whether or not it chooses to cut interest
rates.

Warren Buffett declined to offer an opinion on the stock
market's current valuation at a Berkshire stockholder meeting. But he did
disclose that Berkshire is holding $9 billion in cash. Wall Street Journal 98-09-17

At the annual meeting of the Federal Reserve Bank of Kansas City in
Jackson Hole, Wyoming, over the weekend, some central bankers were privately
admitting that these are the worst global economic conditions they have seen in
their lifetime.

Thanks to the bull market, the measured wealth of American households
has doubled over the past three years. This has made consumers feel richer, and
as a result they have saved less and consumed more. In the second quarter of
this year Americas personal savings rate fell to a historic low of 0.6%,
with consumer spending jumping at an annual rate of 6%.

Rising share prices also made it cheaper for firms to raise equity
finance, so fuelling a surge in investment. The risk now is that this could all
go into reverse, as plunging share prices dent consumer and business
confidence. If the Dow Jones stays close to its current level of nearly 8,000,
then the impact on consumer spending may be small, as that still leaves the
market 25% higher than in December 1996.

But by such measures as price/earnings ratios or the yield gap, Wall
Street is still significantly overvalued  the more so since profit growth
this year seems to have flattened out.

Indeed, the real fear is that the new European Central Bank, anxious to
establish its credentials as guardian of the worlds second currency, the
euro, will be inclined to be too tough. Peripheral economies such as
Irelands and Spains have been showing signs of incipient inflation.
And the ECB is eager to inherit the fearsome reputation of the German
Bundesbank. Should the euro economies falter, there must be a risk that the ECB
will be too slow to respond by easing monetary policy.

First, until the early 1930s countries were on the gold
standardunder which their currencies were tied to gold. This restricted
their ability to ease monetary policy as economies went into recession after
the Wall Street crash of 1929.

Second, governments compounded their tight-money mistake with tight
fiscal policies, even in the depth of the depression. Rather than allowing
taxes to fall automatically as incomes declined, the Americans raised taxes in
1932 to balance the budget. Not only do governments have a better understanding
of macroeconomics today (Dennis, Feldt, Bildt, Wibble, Åsbrink och
Persson), but now that public spending takes a much bigger share of GDP, their
ability to stabilise demand is greater. Edited excerpts from
The Economist 98-09-04

International financial commentators have become so obsessed with
Japans various failures that a very serious macroeconomic disequilibrium
now emerging in the USA has been almost unnoticed. A standard line has been
the American economy will slow down when the full effect of the Asian
crisis comes through. This is tantamount to saying that the
American economy will slow down because the balance of payments is moving
heavily into the red.

Indeed, the deficit on the current account of the USAs balance of
payments in 1998 will be the largest that the world has ever seen. Hardly any
concern is being expressed by governments or in financial markets about the
medium-term implications of this development.

The scale of the deficit would be remarkable even if the USA were a
substantial lie creditor nation. But, in fact, foreign-owned assets in the USA
exceeded the USAs foreign assets by over $1,300b. at the end of last
year.

The current arts account deficit in the first quarter (Q 1) was $47b.
and will undoubtedly increase, perhaps towards $60b., in Q2.

The current account deficit may be $230b. - $250b. in 1998 and a rather
higher figure of, say, $300b. in 1999 and 2000.

The USAs negative position on its international investments
(its net debt) may by the end of 2000 be almost $2,OOOb., which
would be more than twice the value of its exports.

There is little question that the USA will also have a large and
widening deficit on investment income. (See pp. 8 - 9 of this Review.)
To prevent the external debt running out of control, exports will need to
grow faster than imports for an extended period. But this will require a
drastic wrench to the growth pattern enjoyed over the last six years. Net
exports were a negative influence on GDP in 20 of the 24 quarters to Q1
1998.

What form will this wrench take? Plainly, the growth of domestic demand
will have to run at a beneath-trend rate also for an extended period.

But how likely is that in late 1998 and early 1999 after three years of
high money supply growth, vast capital gains from the asset price bubble and an
extremely buoyant housing market? (Seep. 5, p. 7 and p. 12.) Also
helpful would be a lower dollar.

Sooner or later a fall in the dollar is inevitable, but it probably will
not happen in late 1998.

The favourable interest rate differential compared with other leading
currencies (apart from sterling) protects the dollar and will widen further
when the Federal Reserve tightens.

The resolution of the USAs external disequilibria will begin to
become part of policy-makers agenda only next year and thereafter.

But the longer the deficit persists, the greater will be
foreigners accumulation of claims on the USA and the worse the eventual
problem of adjustment.

CNN: The US trade deficit soared by 10% to a record $15.75bn in May, the
highest since the current monthly series began in 1992. The trade gap is
running at a record annual rate of $150bn, up almost 50% on last year's figure,
based on the first five months of the year. The figures came as a surprise to
analysts, who were expecting an improvement in the trade deficit after April's
record gap of $14.5bn.

A yawning trade chasm is opening up for the US, which experienced a
record goods and services deficit of $15.75bn for May and could be heading for
a total deficit of more than $200bn (£122bn) for 1998.

Economists are scratching their heads over the impact on the US economy
in the second quarter. On the one hand, domestic demand continues to race along
at between 5 per cent and 6 per cent. America is booming and no wonder when, as
J.P. Morgan's Philip Suttle points out, accruing capital gains on financial
assets are adding two-thirds to normal household incomes.

On the other hand, deduct the rocketing share of net imports and further
subtract a necessary inventory correction and you have a sharp GDP slowdown: a
drop from 5.4 per cent annualised in the first quarter to just 1 or 2 per cent.

One consequence of these distortions is a squeeze on profits,
particularly in manufacturing, as pricing power disappears; production stalls
(especially for export) with negative implications for productivity growth
while domestic costs edge higher.

Yet Wall Street could not care less, having gained yet another lease of
life in this geriatric bull market. The Standard &amp; Poor's 500 Index has
raced ahead by 10 per cent since mid-June, and most indices have been hitting
new all-time highs (although the smaller capitalisation Russell 2000 Index has
not been invited to the party).

There is a clue in the surge of liquidity in the US in recent weeks. The
Federal Reserve feared any US monetary tightening could have outsized
effects; on Asia, Alan Greenspan, Fed chairman, told the Senate Banking
Committee yesterday. According to CrossBorder Capital, a London consultancy
that monitors global liquidity, in an apparent policy reversal the Fed has been
opening wide the taps CrossBorder says that free reserves of the US
banking system, after falling all year until June, have doubled in a few weeks.
Broad money growth, meanwhile, continues to be stimulative - at some 10 per
cent year-on-year. There seems to be a clear link with the renewed upturn on
Wall Street.

BIS-Bankens i Basel VD Juni 1988

However, the year has contained darker elements as well. The Japanese
economy has thus far failed to respond to repeated policy initiatives, and the
crisis among trading partners elsewhere in Asia raises the possibility of
mutually reinforcing weakness in the region as a whole.

The sharp decline in commodity and oil prices will place a heavy burden
of adjustment on a number of already fragile economies.

The buoyancy of stock markets and bond markets in industrial countries,
and the strength of capital inflows into non-Asian emerging markets, could in
themselves be described as good news. Yet the enthusiasm of financial markets
also raises another spectre: that it may not last, and that the economic
effects of such a change in sentiment might be difficult both to predict and to
manage.

The economic expansion in the industrial world is still being led by the
United States, where the economy has continued to grow rapidly under the
influence of strong domestic demand and healthy productivity gains.
Developments in the United Kingdom have mirrored the US experience in some
respects.

The economic and financial drama unfolding in Asia over the last year or
so has understandably puzzled and preoccupied both policy-makers and market
participants. The deterioration in the economic fortunes of many of the
affected economies has been extraordinary, particularly given the widespread
belief that their earlier successes were based on sound fundamentals.
Unfortunately, these earlier successes seem to have contributed as well to a
climate of excessive optimism among both borrowers and lenders. As a result,
inadequate attention was paid to the rapid build-up of domestic and foreign
debt by domestic corporations.

Also ignored was the significant threat this would pose to the stability
of local banking systems should heavily managed exchange rate regimes come
under pressure. Once difficulties emerged, a sharp and simultaneous
reassessment of exposures to liquidity risk, market risk and credit risk then
turned what might otherwise have been an orderly adjustment into a prolonged
crisis.

We should not forget that a counterpart to strong growth with low
inflation in both the United States and the United Kingdom has been a firming
of the exchange rate and a widening of the trade deficits.

So far such deficits have been easily financed. However, a greater
degree of hesitancy on the part of foreign investors could alter this situation
and, in turn, the role played by the exchange rate in keeping domestic
inflation subdued. Monetary policy might then need to take more of a leading
role in maintaining price stability, and this would be all the more likely were
the recent downward trend in commodity prices to reverse.

A closely related issue is the current buoyancy of financial asset
prices in many industrial countries, amid associated concerns that investors
everywhere may be underestimating the riskiness of certain kinds of financial
investment.

In setting monetary policy, the implications of rising asset prices for
spending and inflation must obviously be taken into account.

The experience of Japan, the Nordic countries and the United States in
the early 1990s, and other parts of Asia more recently, indicates that asset
price bubbles fuelled by bank credit can cause lasting damage to the banking
system and to the broader economy.

While property prices figured prominently in earlier crises, and such
prices have only just begun to turn up in many industrial countries, the
current rapid expansion of monetary aggregates in a number of countries needs
to be closely monitored.

There were good reasons to think that Hong Kong would be insulated from
the Asian crisis.... But it could not escape some fallout. The main impact has
come through higher interest rates, which led to large falls in the asset
markets - property prices have fallen 30-40 per cent since their peak last
October. Retail sales have slumped, as has tourism, falling by 25 per cent
year-on-year as Asian tourists stayed at home.

The key concern is how far house prices can fall. With Hong Kong's banks
heavily exposed to the property market, a collapse in prices could threaten the
stability of the financial system, a pillar of the economy.

So far there is no reason for panic. Most of the fall in property prices
is the correction of a bubble. Prices had risen by more than 40 per cent
between the third quarter of 1996 and their peak in 1997, causing serious
concerns about Hong Kong's competitiveness. An adjustment had to come at some
point. Moreover, the limits on mortgage lending in Hong Kong are very strict,
giving the financial system some protection.

The government must tread a fine line. It must prevent the slump from
getting too deep but should not overreact and resort to crude interventionism.
Its reaction has so far been sensible. It has been robust in its defence of the
currency link. And it is providing the economy with a fiscal stimulus through a
combination of tax cuts and infrastructure projects. (Kommentar RE: Är det
inte misstänkt likt s k förlegad keynesianism?)

Housing policy is crucial. Hong Kong's new government last year
announced a programme of accelerated land release and homebuilding. But
implementing this now could send prices into freefall. Hong Kong's chief
executive, C.H. Tung, gave a welcome indication in a speech this week that he
was prepared to relax the policy. Most important, Hong Kong must avoid panic
measures. Trying to hold interest rates down artificially or pumping money into
unnecessary infrastructure will only worry the markets and lead to
inefficiencies.

Different Times, but the 1990s Do Resemble
the 1920s By Robert J. Samuelson The Washington Post International
Herald Tribune, Thursday, April 23, 1998

Americans know that today's economic boom will someday end, because
all booms do. Yet faith in its immortality seems to grow almost daily. You see
it in the stock market, confidence indexes and tight labor markets. Has there
ever been anything like it? Well, how about the 1920s? The suggestion seems
anti-social. It raises the specter of another Great Depression. (Unemployment
averaged 18 percent in the 1930s.)

This need not be, of course. Peering back teaches at least two
important lessons: People do get carried away, and today's economy may have
some little-noticed weaknesses.

Parallels with the 1920s abound. The stock market soared. New
technologies daz-zled. Today it is personal computers and the Internet. Then it
was radios and mass-produced cars. From 1919 to 1930, the number of radios went
from almost zero to 14 million; car registrations tripled to 23 million.

Then as now, people thought that the economy had permanently changed
for the better. The 1920s supposedly heralded a ''new era.'' The operative
phrase in the 1990s is ''the new paradigm.''

It holds that favorable forces (computers, foreign competition,
deregulation) have made the economy more competitive, more productive and more
stable. The economy is now said to lack the ''excesses'' that typically trigger
a recession. Inflation is low; there is not much obvious business
overinvestment (in, say, office buildings). But this overlooks the stock
market, which may be just such an ''excess.'' It may be nudging the economy
along by bolstering consumer confidence and spending.

Higher stock prices, it seems, embolden people to spend more of their
incomes. They feel wealthier. Or they cash in - and spend - some market
profits. The extra spending sustains the expansion. As the market has risen,
the personal savings rate has fallen. In 1992 it was 6.2 percent of disposable
income; by 1997 it had sunk to 3.8 percent, the lowest since at least 1946.

And why shouldn't consumers feel cocky? The market's surge now rivals
the 1920s run-up as history's greatest. Ned Davis Research Inc. dates the
present bull market to Oct. 11, 1990, when the Dow Jones Industrial average was
at 2365.10. Since then it has risen by 288 percent (based on the April 17 close
of 9167.50). In the 1920s, stocks rose by 345 percent from October 1923 to
September 1929.

Stock prices have almost quadrupled in value since 1990. On Oct. 11,
1990, Ford closed at a little less than $10 a share; now it trades just under
$50

This has meant an explosion of personal stock wealth. At year-end
1990, the value of households' stock holdings was $3.1 trillion. By 1997, that
was $11.4 trillion. (These figures include stocks held through mutual funds,
retirement accounts and pensions.)

Perhaps this: Stocks ultimately drop; confidence, bolstered by their
rise, sags with their fall; consumer spending weakens or maybe declines.
Consumer spending represents about 68 percent of the American economy's output.
If it weakens, corporate investment might be excessive; cutbacks could occur.

The point is that the stock market is not merely an indicator of the
economy's performance. The market also determines how the economy behaves,
through mass psychology and consumer spending.

In the 1990s, just as in the 1920s, stock wealth has soared and
ownership has spread. It is creeping down from its bastion among the rich and
upper middle class. Among families with incomes ranging from $10,000 to
$25,000, stock ownership rose from 13 to 25 percent from 1989 to 1995, reports
the Federal Reserve. For families with incomes from $25,000 to $50,000,
ownership went from 33 to 48 percent.

In the late 1920s, warnings that the market was overvalued did not
deflate the mania. One reason was that until early 1928 the market's rise
reflected higher profits and dividends. Most of the 1990s surge also rests on
solid economic gains. Inflation and interest rates have declined; this makes
stocks worth more, because competing interest-bearing investments (bonds, bank
deposits) are less attractive. And profits have doubled since 1990, boosting
stocks.

But the market has moved well beyond present profits. Its
price/earnings ratio is now at a historical high of 28. Since World War II, the
ratio has averaged about 14. Something much higher may now be warranted. But
28? Who knows?

Perhaps higher prices will ultimately be vindicated by economic
conditions (lower interest rates, high profits). Even if stocks dropped by 15
or 20 percent now, investors and consumers might take the decline in stride.
After all, stock prices would still be where they were in early 1997, and more
than twice their early 1991 level. And the 1990s are not the 1920s.

Although the crash of 1929 (the Dow dropped by 48 percent from
September to mid-November) did mark the start of a sharp recession, it did not
cause the Depression. The Depression occurred because the Federal Reserve did
not do its job.

It allowed 11,000 banks to become insolvent by 1933, and it permitted
the money supply to drop by a third. These were preventable events that would
probably now be prevented. It is dangerous to overdo historical analogies. The
1920s cannot tell us whether today's boom will end next week, next month or
even next year. But the history is mighty intriguing, and leaves a sobering
question.

The economy has surely changed since 1929, but has human nature?

Small investors continue to believe Wall Street is the best place
USA Today 04/21/98 utdrag:

Small investors continue to believe Wall Street is the best place for
their money, despite the highest stock prices in history and worries about
global turmoil. Two-thirds of Americans think stock prices will rise the next
six months, according to a USA TODAY/CNN/Gallup poll. A similar number say if
they had $1,000, investing it in stocks would be a ''good idea.''

That bullishness startles Yale Hirsch, editor of the Stock Trader's
Almanac. A bull market usually peaks when 50% to 60% of investors think stock
prices will continue to rise, he says. The positive outlook is comparable to a
poll taken last November amid fears of Asian economic collapse and when stocks
were well off their highs. Since then, investors have helped fuel the rise in
stock prices.

They pumped more than $66 billion into stock mutual funds during the
first quarter, the Investment Company Institute estimates. But, Hirsch says,
eventually the amount of money flowing into the stock market will level off,
and demand will sag. ''If everyone is wildly bullish, all their funds are
committed and they don't have any more money to invest,'' he says.

Many market pundits say the rise in stock prices is justified because
inflation is barely visible, interest rates are low and economic growth is